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Outlook

Investment Management Division

US Preeminence

Our six-year investment theme endures.

Investment Strategy Group | January 2015

Sharmin Mossavar-Rahmani
Chief Investment Officer
Investment Strategy Group
Goldman Sachs

Brett Nelson
Head of Tactical Asset Allocation
Investment Strategy Group
Goldman Sachs
Additional Contributors
from the Investment
Strategy Group:
Matthew Weir
Managing Director
Maziar Minovi
Managing Director
Benoit Mercereau
Managing Director
Farshid Asl
Managing Director

This material represents the views of the Investment Strategy Group in


the Investment Management Division of Goldman Sachs. It is not a product
of Goldman Sachs Global Investment Research. The views and opinions
expressed herein may differ from those expressed by other groups of
Goldman Sachs.

2 01 5 O U T LO O K

Overview

the preeminence of the united states has driven our

investment views for the past six years and over this time we have
recommended clients maintain the core of their strategic allocation
in US assets. Since the global financial crisis, the United States has
outpaced major developed and emerging market countries and
regions across economic, financial and human capital dimensions.
With US equities now some 240% higher than their 2009 trough,
we have to ask: Has the investment theme of US preeminence
already played out?
We answer that question in the pages that
follow by examining key measures and showing
that the gap between the United States and other
major countries and regions has widened relative
to pre-crisis levels. The United States continues to
build on its strengths, ranging from immigration to
innovation, while many other key developed and
emerging market countries and regions are held
back by their structural fault lines, ranging from
demographics to governance. Our analysis shows
that the full scale of US preeminence has not yet
been fully factored in or discounted.
We believe that our six-year investment
theme will therefore endure for the foreseeable
future. We continue to recommend maintaining
a strategic overweight to US equities relative to
their share of global market capitalization. While

Outlook

Investment Strategy Group

we advise our clients to stay fully invested in


US equities, we recommend caution, given that
valuations are in the 9th decile of their historical
range in the post-WWII period. It also needs to
be said that US preeminence does not mean that
US assets consistently will outperform or avoid
bouts of volatility. But even after their staggering
outperformance in recent years, we believe that US
assets can continue to do well.
In this report, we include our return
expectations for all major asset classes for the
next one and five years, along with the key risks
that could alter their trajectory. The balance of the
report is dedicated to an in-depth discussion of
the outlook for the major developed and emerging
economies, global equities, currencies, fixed income
and commodities.

2 01 5 o u t lo o k

Contents

SECTION I

US Preeminence

Our Six-Year Investment Theme Endures

25 The Risks to Our Investment Views

8 US Preeminence: The Gap Widens


We believe that US preeminence is not fully
priced into markets, and that our six-year
investment theme will endure through 2015.

26 Federal Reserve Tightening

8 Widening Gap across Most Key Economic


Metrics
13 Widening Gap across Financial Markets
17 Widening Gap across Human Capital
Factors
18 Is the Widening Gap Cyclical or Structural?
19 Investment Implications of the Widening Gap
19 Strategic Implications
20 Tactical Tilt Implications
25 Prospective Returns

Goldman Sachs january 2015

28 Eurozone Crisis Is Reignited


30 The Unpredictable President Vladimir
Putin
31 Geopolitical Risks of 2014 Spill Over into
2015
32 Ebola Epidemic
32 Key Takeaways
We maintain our recommendation that clients
stay fully invested in US equities with some
tactical overweight allocations to high yield
bonds and to the US dollar relative to the euro
and the yen.

S E C T I O N I I : G lo b a l D ivergences

2015 Economic
Outlook

S E C T I O N I I I : N o t Y e t O u t t o Pas t u re

2015 Financial
Markets Outlook

34

48

36 United States

50 US Equities

40 Eurozone

54 EAFE Equities

42 United Kingdom

56 Eurozone Equities

43 Japan

57 UK Equities

44 Emerging Markets

58 Japanese Equities
60 Emerging Market Equities
61 Global Currencies
65 Global Fixed Income
73 Global Commodities

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Investment Strategy Group

SECTION I

US Preeminence:
Our Six-Year Investment
Theme Endures

the preeminence of the United States has driven our

investment views and annual Outlooks since the dark days


of 200809. While the prevailing sentiment in the investment
community during the global financial crisis was to turn
away from US assets, with some even questioning the dollars
status as the worlds reserve currency, the Investment Strategy
Group focused on the inherent strengths of the United States.
We highlighted its immense wealth, vast natural resources,
institutional strengths and human capital advantages.
In our 2009 Outlook, Uncertain But Not Uncharted, we
compared the crises of the 1970s, early 1980s and early 1990s
to that of 200809 and demonstrated that the US economy and
US financial markets not only survived, but prospered in the
aftermath of these crises. In Take Stock of America, our 2010
Outlook, we delved deeper into the fundamental strengths of the
US economy and the contribution of such factors as immigration,
technological innovation, a stable political system and even a
powerful military; we rejected the oft-expressed view that the
200809 crisis had dealt a fatal blow to the United States as
4

Goldman Sachs january 2015

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Investment Strategy Group

Exhibit1: Cumulative Equity Returns Since March


2009

Exhibit2: Equity Markets Distance from Pre-Crisis


Peaks

US equities have outperformed since their 2009 trough.

The US is the only major equity market above its 2007 peak.

Cumulative Return
Since 3/9/2009

Distance from
Pre-Crisis Peak

250%

244%

US
Eurozone
Japan
Emerging Markets

200%

40%
30%

32%

20%
10%

150%

136%
131%
126%

100%

0%
-10%
-20%

50%

-30%

0%
Mar-09

-28%

-24%

-29%

-40%
Feb-10

Jan-11

Dec-11

Nov-12

Oct-13

Sep-14

US
(Peak: 10/9/07)

Eurozone
(Peak: 6/1/07)

Japan
(Peak: 2/26/07)

Emerging Markets
(Peak: 10/29/07)

Data as of December 31, 2014.


Note: Based on S&P 500, MSCI EMU Local, MSCI Japan Local and MSCI EM US$ total return indexes.
Source: Investment Strategy Group, Datastream.

Data as of December 31, 2014.


Note: Based on S&P 500, MSCI EMU Local, MSCI Japan Local and MSCI EM US$ price indexes.
Source: Investment Strategy Group, Datastream.

the predominant economic and geopolitical power.


In our 2011 Outlook, Stay the Coursewhich
featured Emanuel Leutzes painting of George
Washington crossing the Delawarewe continued
this theme and touched on US corporate resiliency,
favorable demographics, elite universities and
dominant position in public and private research
and development. In our three subsequent annual
Outlooks, we contrasted these US strengths with
the structural fault lines of the Eurozone, Japan
and the largest emerging markets of Brazil, Russia,
India and China (BRICs).
Our analysis invariably led us to two key
investment recommendations for our clients over
the past six years. And these recommendations
remain valid for our 2015 Outlook.
First, we continue to recommend that our
clients strategically allocate a significant portion
of their portfolios to US assets and at well above
market capitalization levels. Our standard
moderate-risk model portfolios for taxable and
tax-exempt US clients had a strategic allocation
to US assets between 80% and 85% in 200914
(80% in 2015). For our European clients with the
euro as their base currency, our strategic allocation
to US assets for a moderate-risk portfolio has
ranged between 37% and 44% (44% in 2015),
with the primary difference resulting from the fixed
income portion of the portfolio, which is allocated
to clients base currency.

Second, many of our tactical tilts, especially


earlier in this bull market, have been focused on US
equity and US high yield overweight allocations,
reaching peak levels in September 2009. In fact, a
key takeaway of many of our Outlooks, Sunday
Night Insights and periodic conference calls
in which many of you participated was to stay
invested at your strategic allocation to US equities,
with specific tactical tilts highlighted at various
times. We have made this recommendation 45
times since 2009, if you were counting.
With US equities now some 240% higher than
their 2009 trough, is US preeminence already
priced into US financial assets and is it time for
a change in investment stance with respect to
strategic and tactical allocations? Six years is a long
time for an investment theme to play out, and it is
important not to miss other attractive long-term
investment opportunities. Moreover, the magnitude
of the outperformance of US financial assets
relative to their counterparts has been staggering.
Can this continue?
To answer this question, let us first explore
the extent to which US financial assets have
outperformed other global asset classes.
Leading up to the trough in March 2009, US
equities experienced daily price declines of as much
as 9% and market volatility1 as high as 89%. With
the onset of recovery and through the end of 2014,
US equities have outperformed Eurozone, Japanese

Goldman Sachs january 2015

and emerging market equities by 108%, 118%


and 113%, respectively, as shown in Exhibit1. On
an annualized basis, these numbers equate to an
outperformance of 8%, 9% and 8%, respectively.
Notably, US equities are 32% above their October
2007 peak, whereas the Eurozone, Japanese and
emerging market equities are all still below their
October 2007 levels. Indeed, as shown in Exhibit2,
no major market other than that of the United
States has exceeded its own pre-crisis peak over
this period as measured by MSCI indexes.
US preeminence has also played out in high
yield. Since its trough in late 2008, US high yield
has had very strong outperformance relative to
emerging market (EM) assets, outperforming
emerging market local debt by 126% (11%
annualized) and emerging market dollardenominated debt by 74% (6% annualized), as
shown in Exhibit3.
European high yield was more volatile over
the course of the financial crisis, partly due
to its initial underperformance at the onset of
the global financial crisis and partly due to its
underperformance during the Eurozone sovereign
debt crisis. For example, between May 21, 2008,
and November 21, 2008, European high yield
underperformed US high yield by 13.5%. We
therefore believe we should compare US high yield
and European high yield from the beginning of
2007 to cover a broad period and iron out the
impact of extreme moves in the European highyield market. Over this period, while US and
European high yield have had nearly identical
returns, US high yield has had 40% lower volatility.
The shift in sentiment toward the US dollar
is another acknowledgment of US preeminence
by global financial markets. As early as 2005,
economists and currency experts predicted the end
of the reign of the US dollar as the reserve currency
of the world. Professor Jeffrey Frankel of Harvard
University suggested that the euro could surpass
the dollar as the leading international reserve
currency by 2022.2 In early 2008, he brought
forward this forecast to as early as 2015.3 Similarly,
Professor Barry Eichengreen of the University of
California, Berkeley, suggested in 2009 that the
dollar would weaken and central banks would start
considering alternatives.4 In 2011, he wrote that
the dollars reign is coming to an end.5

Outlook

Investment Strategy Group

Exhibit3: Cumulative Fixed Income Returns Since


December 2008

Since its trough, US high yield has outperformed emerging


market debt.
Cumulative Return
Since 12/12/2008
190%
165%
140%

US High Yield

171%

EM Local Debt
EM Dollar Debt

115%
97%

90%
65%

45%

40%
15%
-10%
Dec-08

Dec-09

Dec-10

Dec-11

Dec-12

Dec-13

Dec-14

Data as of December 31, 2014.


Note: Based on Barclays US Corporate High Yield, JPM GBI-EM Global Diversified and JPM EMBI
Global Diversified total return indexes.
Source: Investment Strategy Group, Datastream.

Dmitry Medvedev, Russias former president


and now prime minister, warned in 2009 that
wobbly American financial policy had made the
dollar an undesirable currency for reserves held by
central banks.6 He suggested central banks consider
regional currencies, like the Russian ruble.
In reality, since the October 2007 peak of US
equities, the dollar has outperformed the euro, the
yen and every other currency of its major trading
partners (with the exception of the Swiss franc),
as well as broad baskets of emerging market
currencies, by anywhere from 1% to 4% on an
annualized basis. The dollar has appreciated 92%
versus the ruble since Medvedevs warning.
While it is clear that financial markets are
acknowledging the strengths and comparative
advantages of the United States, we believe that
the full scale of US preeminence has not yet been
fully factored in or discounted. Remarkably, the
gap between the United States and other major
countries and regions is widening across a range of
economic, financial and human capital dimensions.
Our six-year investment theme will therefore
endure through 2015.

The introductory section of our 2015 Outlook


begins by examining the key areas where the
gap between the United States and other major
countries and regions has widened. The gap
has widened as the United States builds on its
strengths, ranging from immigration to innovation,
while so many others are held back by their
structural fault lines, ranging from demographics
to governance. We then discuss key investment
implications as well as our expected returns for
2015 and for the next five years. We conclude with
the risks to our outlook.
In the second section of our Outlook, we present
our economic views for the key regions of the world,
with emphasis on their diverging paths. The third
section concludes with a more detailed investment
outlook for the major marketable asset classes.

Exhibit4: Real GDP Growth Since Pre-Crisis Peak

US growth has far outpaced that of the Eurozone and Japan.


10%
8%

8.1%

6%
4%
2%
0%
-1.1%

-2%

-2.2%

-4%
US
(Peak: Q4 2007)

Eurozone
(Peak: Q1 2008)

Japan
(Peak: Q1 2008)

Data through Q3 2014.


Source: Investment Strategy Group, Datastream.

US Preeminence: The Gap Widens


Since WWII, the United States has exhibited its
preeminence across a wide range of economic,
military, institutional and human capital factors.
During periods of financial and economic stress,
this preeminence is invariably questioned both
within and outside the United States, and the
200809 crisis was no exception. For example,
many financial market participants, the media,
think-tank pundits and academics hailed the end of
the American Century and start of the Chinese
Century. And as in past periods of financial and
economic stress, the sentiment has reversed. The
declinists are in retreat and the recognition of US
preeminence has taken hold.
Once again, the United States has emerged
economically and financially stronger than other
major countries and regions, and the gap between
the United States and the rest of the world has
actually widened. The Eurozone and Japan
have experienced weak-to-negligible growth,
compounded by limited structural reforms. Most

Declinists are in retreat and the


recognition of US preeminence has
taken hold.

Goldman Sachs january 2015

key emerging market countries, with the notable


exception of India, have experienced slowly
to rapidly deteriorating economic conditions,
compounded by very limited to nonexistent
structural reforms and, in some cases, actual
regression with respect to such measures as
corruption and economic freedom.
We begin by examining this divergence between
the United States and the rest of the worlds key
countries and regions across three categories:
economic, financial and human capital. While the
United States has not outperformed across every
metric in every category, the picture that emerges is
of an economy on a much stronger footing, backed
by a more stable and streamlined private sector.
Widening Gap across Most Key Economic Metrics

GDP and GDP per Capita Growth: After a


relatively slow and uneven start to the economic
recovery, US growth is now on solid ground, with
US GDP 12.9% above its 2009 trough,
compared with 3.8% for the Eurozone
and 8.9% for Japan. Importantly, the
United States has exceeded its pre-crisis
GDP peak by 8.1%. The Eurozone and
Japan are still below their pre-crisis GDP
peaks by more than 1%, as shown in
Exhibit4.

Exhibit6: Nominal GDP per Capita

Emerging market growth, once sizzling, is now fizzling.

The gap in GDP per capita between the US and others has
widened.

EM - US Real GDP Growth

US$ thousands

8%

60

EM grows
faster

6%

ISG
Forecast

Thousands

Exhibit5: EM vs. US Growth Differential

US
Japan
Russia

50

4%

40

2%

30

0%

20

-2%

10

Eurozone
China
India

UK
Brazil

44.1
42.8
37.5

14.3
11.1
7.6
1.6

-4%
1996

1998

2000

2002

2004

2006

2008

2010

2012

2014

54.7

2000

2002

2004

2006

2008

2010

2012

2014

Data forecast through 2015.


Note: For informational purposes only. There can be no assurance that the forecasts will be achieved.
Source: Investment Strategy Group, Datastream, IMF.

Data through 2014.


Source: Investment Strategy Group, Datastream, IMF.

Growth in key emerging market countries has


been substantially higher over this period. From
their pre-crisis peaks, the GDPs of Brazil, China,
India and Russia are higher by 12%, 74%, 43%
and 4%, respectively. However, US growth has
been on an upward trajectory over the last several
years, while that of emerging market countries,
including the BRICs, has been on a downward
slope. While emerging market countries grew at
a much faster rate than the United States at the
turn of the 21st century, this differential peaked
at 6.5% in 2007 and has been declining ever
since (see Exhibit5). Emerging market countries,
including the once-sizzling, now-fizzling growth
markets, are estimated to have grown faster than
the United States in 2014 by only 2.6%. We
expect this differential to narrow to a mere 1.2%
in 2015 as China slows down further and Russia
falls into recession.
In 2007, when these emerging market countries
were growing by 8% in aggregate, no one imagined
that by 2015, the expected incremental growth
relative to the United States would drop to 1.2%.
Notwithstanding the shrinking growth
differential, emerging market countries have been
growing faster than the United States for decades,
but, remarkably, not fast enough to prevent the
widening of the gap between their GDP per capita
and that of the United States. Again, measuring
from 2007, US GDP per capita has climbed 14%

through 2014 while Chinas has risen an eyepopping 185%. Yet, given the substantially higher
starting level in absolute terms of US GDP per
capita of $48,000 in 2007, the gap in dollars has
actually widened relative to the Eurozone, Japan
and the BRICs, as shown in Exhibit6. As we have
noted in the past, under a range of reasonable
growth assumptions for the United States and
China, we estimate that Chinas GDP per capita
will not match that of the United States in this
century, even though its overall GDP may surpass
that of the United States in the next few years.
Looking to 2015, we expect the GDP gap
between the United States and key developed and
emerging market countries and regions to widen
further. We expect US growth to accelerate to
over 3%, while the Eurozone and Japan should
each grow at just below 1%. Growth in emerging
market countries in aggregate is expected to slow
down marginally.
What is striking about current US GDP
growth is that it is broad-based, with all major
sectors of the economy contributing to growth
relative to prior years. This breadth of recovery
across residential and nonresidential investments,
consumption and exports, along with an end to
the fiscal drag from the government sector, is not
being replicated in other developed economies.
For example, nonresidential investment bottomed
in the United States in 2009 and, according to the

Outlook

Investment Strategy Group

Exhibit7: Household Leverage

Exhibit9: Financial Sector Leverage

US households have meaningfully reduced debt as a share


of GDP.

The magnitude of deleveraging in the US is greatest in the


financial sector.

Cumulative Change (% GDP)

Cumulative Change (% GDP)

20%

30%

US
Japan
Eurozone
EM
China

15%
10%

20%
10%

5%

0%

0%
-10%

-5%

-20%

-10%

-30%

-15%
-20%
Dec-07

Mar-09

Jun-10

Sep-11

Dec-12

Mar-14

-40%
Dec-07

US
Japan
Eurozone
BRICs
China
Mar-09

Jun-10

Sep-11

Dec-12

Mar-14

Data through Q2 2014.


Source: Investment Strategy Group, BIS, Datastream, IMF.

Data through Q2 2014.


Source: Investment Strategy Group, BIS, Datastream, IMF.

Exhibit8: Nonfinancial Corporate Leverage

than the Eurozone and Japan. Exports account


for 13% of GDP in the United States, compared
with 19% in the Eurozone and 17% in Japan. Yet
exports in the United States are 18% above their
pre-crisis peak while Eurozone exports are 10%
above and Japan exports are notably more than
2% below.
Section II of this Outlook discusses our 2015
economic views in greater detail.

Chinese companies increase in debt stands in sharp contrast


to US deleveraging.
Cumulative Change (% GDP)
60%

US
Japan
Eurozone
EM
China

50%
40%
30%
20%
10%
0%
-10%
Dec-07

Mar-09

Jun-10

Sep-11

Dec-12

Mar-14

Data through Q2 2014.


Source: Investment Strategy Group, BIS, Datastream, IMF.

latest statistics, is 7% above its pre-crisis peak. In


the Eurozone and Japan, nonresidential investment
is 14% and 9% below peak levels, respectively.
Similarly, private consumption is 9% above its
2007 peak in the United States, while it is more
than 1% below peak in the Eurozone and about
3% above peak in Japan.
Even the US export sector is exhibiting better
performance, which is notable given that the
United States is traditionally less export-oriented

10

Goldman Sachs january 2015

Deleveraging in the Private Sector: Another area


where the gap between the United States and
the rest of the world has widened is the use of
borrowing and leverage in the private sector. While
US households, nonfinancial corporations and
financial institutions continue to deleverage, their
counterparts elsewhere are borrowing more or, at
best, holding the line. The US household sector has
reduced debt as a share of GDP by 18 percentage
points since peaking in late 2007. This is in
contrast to a modest increase in the Eurozone, no
change in Japan, and a surge in emerging markets
led by China and followed by Brazil and Russia
(see Exhibit7).
We see a similar pattern in nonfinancial
corporations. US companies have reduced debt
as a share of GDP by two percentage points
since 2007, but other developed and emerging

Exhibit10: US Federal Budget Deficit

Exhibit11: Change in Budget Deficits Since 2007

The US federal deficit has narrowed to a post-crisis low in


fiscal year 2014.

The US budget deficit has widened by less than other


countries.

% GDP
3%

Change Relative
to 2007
10%

1%

7.7

8%
6%

-1%

Wider deficits

4%
-3%

2%

1.7

2.3

1980

1986

1992

1998

2004

2010

EM

Japan

Greece

Ireland

Portugal

Spain

Italy

France

Germany

1974

Eurozone

1968

US General

1962

-4.1
US Federal*

-11%
1956

0.8

-6%

Post-WWII Average

1950

1.4

-4%

Deficit
-9%

1.9
-0.1

-2%
-7%

3.1

2.2

0%

-5%

5.0

4.4

Data through FY 2014.


Source: Investment Strategy Group, Datastream.

Data through 2014.


Source: Investment Strategy Group, Datastream, IMF.
* Refers to realized fiscal year numbers.

market companies have increased their debt levels


significantly; Chinas increased by 52 percentage
points, as shown in Exhibit8.
The magnitude of US deleveraging is greatest in
the financial sector. Financial sector debt as a share
of GDP has decreased by more than 30 percentage
points in the United States since the end of 2007,
compared with an increase of 3 percentage points
in the Eurozone, a decrease of 8 percentage points
in Japan, and an increase of 6 percentage points in
China, as shown in Exhibit9.
The US private sector is entering 2015 with a
substantially improved debt profile relative to key
developed and emerging market countries.

improvement from the deficits peak level of


9.8%, as shown in Exhibit10. The 2.8% level
also compares favorably with the long-term
deficit of 2.3% since WWII. However, the general
government deficit, which includes state and local
governments, is at 5.5% of GDP, compared with a
long-term average of 4%, so the US cannot sustain
such deficits without putting upward pressure on
the debt profile of the country.
Nevertheless, recent reductions in the US
federal deficit are significant and exceed those of
many other countries. As shown in Exhibit11, the
US federal deficit as a share of GDP is only 1.7
percentage points higher than levels seen in 2007.
We have included changes in the general deficit in
the United States as well since this measure is more
comparable with global deficits and is the standard
used by the International Monetary Fund (IMF).
On this measure, the US deficit is 2.3 percentage
points above its 2007 lows. In comparison, the
Eurozone deficit has deteriorated by 2.2 percentage
points, Japans by 5 percentage points and that of
emerging markets by 3.1 percentage points over
this period. If we incorporate the IMFs estimates
of Chinas augmented budget deficitthe reported
budget deficit augmented by provincial debt and
some other liabilitiesemerging market deficits
have deteriorated by 5.1 percentage points.

Deficits in the Public Sector: The significant


improvement in the US fiscal situation has also
exceeded expectations. You may recall the oftquoted economists Carmen Reinhart and Kenneth
Rogoff, co-authors of This Time Is Different, who
repeatedly warned7 that the US recovery from the
financial crisis was likely to follow the path of postcrisis developed and emerging market recoveries,
with prolonged periods of large deficits. This view
gained credence in August 2011, when Standard &
Poors downgraded US Treasury debt as the federal
deficit rose above 8% of GDP.
What a difference three years make. In fiscal
2014, the US federal deficit narrowed to a postcrisis low of 2.8% of GDP, reflecting a significant

Outlook

Investment Strategy Group

11

Exhibit12: Change in Budget Deficits Since 2009

Exhibit13: Unemployment Rates

The US has substantially reduced its budget deficits since 2009.

The US labor markets dramatic improvement contrasts with


marginal progress elsewhere.

Change Relative
to 2009

13%

11%

-2%
-4%

-3.5

-3.4

-2.8

-1.7

-2.4

-6%
-8%

US
Eurozone
Japan
EM

12%

0%

-3.3
-5.4

-7.0
-8.0

10%
9%
8%

-6.1

7%

Narrower deficits

-9.0

-10%

6%
5%
4%
3%

EM

-13.0
Japan

Ireland

Portugal

Spain

Italy

France

Germany

Eurozone

US General

US Federal*

-14%

Greece

-12%

2%
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Data through 2014.


Source: Investment Strategy Group, Datastream, IMF.
* Refers to realized fiscal year numbers.

Data through November 2014.


Note: EM line based on weighted average of Brazil, Chile, China, Colombia, Czech Republic, Hong
Kong, Hungary, India, Indonesia, Israel, Korea, Malaysia, Mexico, Peru, Philippines, Poland, Russia,
Singapore, South Africa, Taiwan and Thailand.
Source: Investment Strategy Group, Datastream, IMF.

The US average annual growth rate of


2.4% since the trough of 2009 is a remarkable
achievement in the context of significant fiscal
tightening and private sector deleveraging. As
shown in Exhibit12, the reduction in the US
budget deficit is greater than that of any other
country or region except Ireland and Greece
(both of which reduced their deficits under duress
and pressure from the IMF and the European
Commission). This fact is particularly relevant as
we look to 2015 and beyond. The US responded
and adjusted its deficits at the federal, state and
local levels much more rapidly than many other
governments, and still managed to grow faster than
key developed economies.

at any point during the global financial crisis.


Furthermore, the current unemployment rate of
11.5% belies significant dispersion among the
member countries. In Spain, the unemployment
rate is at an unsustainable 24%; in Greece, it is
even higher, at 26%. In France and Italy, the rates
are over 10% and 13%, respectively. Germany is
the lone exception, with unemployment at 4.9%.
Such high rates in the Eurozone outside Germany
have been the source of some unrest over the last
few years and will likely contribute to political
uncertainty in the Eurozone in 2015a risk we
will discuss later in this section.
In Japan, pro-labor practices and a declining
working age population have kept unemployment
in a relatively narrow band: it has ranged between
3.5% and 5.5% since 1998. Relative to its precrisis trough, Japan has outperformed the United
States on this score.
Job gains in emerging markets have put
their labor markets on par with improvement
in the United States. While unemployment
statistics are not directly comparable to those of
developed markets due to larger informal sectors
in emerging markets, it is surprising that such
rapid growth rates in these countries have not
reduced unemployment rates further. Their doubledigit growth rates have brought their average

Improvement in Unemployment and Inflation:


The recovery in the United States has resulted in
significant improvement in the unemployment rate
and core inflation measures. From its peak levels
during the financial crisis, the unemployment rate
has decreased by 4.2 percentage points and is only
1.4 percentage points above its pre-crisis trough, as
shown in Exhibit13.
The improvement in the US labor market
contrasts with marginal gains, at best, in other
major economies. In the Eurozone, for example,
the unemployment rate is now higher than it was

12

Goldman Sachs january 2015

Exhibit14: Core Inflation

Exhibit15: Crude and Natural Gas Liquids Production

US inflation is running closest to the desired 2% level.

The US has become the largest energy producer six years


earlier than expected.

%YoY

mmb/d,
annual averages

3.5%

US
Eurozone
Japan

3.0%
2.5%

14
12

2.0%

11.7
11.6
10.6

10

1.5%
1.0%

0.5%

0.0%
-0.5%

-1.0%

US
Saudi Arabia
Russia

-1.5%

-2.0%
2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

1980

1984

1988

1992

1996

2000

2004

2008

2012

Data through November 2014.


Note: Data for Japan exclude the impact of the VAT hike in April 2014.
Source: Investment Strategy Group, Datastream.

Data through 2014.


Source: Investment Strategy Group, US Department of Energy.

unemployment rates down to 5.7%, 0.3 percentage


points below the pre-crisis trough and very close to
that of the United States.
Turning to inflation, the United States has been
more successful in approaching its core inflation
target of 2%. As seen in Exhibit14, inflation is
very low in the Eurozone and Japan, with inflation
in the Eurozone on a declining trajectory since late
2011. A more detailed discussion of our outlook
for inflation in these countries and regions appears
in Section II.

a significant increase in production. Since the end


of 2007, production of US crude oil and natural
gas liquids (a byproduct of the crude oil extraction
and refining) has increased by 4.6 million barrels
per day, accounting for 80% of the total increase
in world production. In November 2012, the
International Energy Agency (IEA) forecast that
the US would become the worlds largest oil
producer by 2020, surpassing Russia and Saudi
Arabia.9 Impressively, as shown in Exhibit15,
what was expected to take eight years has occurred
in only two.
The economic and geopolitical implications of
these energy gains are far-reaching for the United
States and its competitive position.

Energy Sector: Another point of differentiation


between the United States and key developed and
emerging economies is the energy sector. As early
as 2009, we referenced the rich natural resources
of the United States.8 In our 2013 Outlook,
Over the Horizon, we outlined the comparative
advantage of the United States across most natural
resources and highlighted how the United States
has widened its lead over other major countries
in oil and natural gas.
The US energy resurgence has exceeded
expectations. Since hitting a low point in 2008,
US proven oil reserves have increased by 55.6%
(or 15.8 billion barrels) as of 2013. Over the
same period, US proven natural gas reserves have
increased by 34.9% (or 2.4 trillion cubic meters).
Along with the increase in reserves, we have seen

Outlook

Investment Strategy Group

Widening Gap across Financial Markets

Performance and Market Share: US equities have


far outperformed other major equity markets
since the trough of the financial crisis. The United
States now accounts for 52.4% of the floatadjusted market capitalization of the MSCI All
Country World Index, compared with 42.7%
at pre-crisis peak levels. Looking at the largest
15 equity markets in the index, only three other
countries showed any increase in market share:
China, with a slight increase of 0.4 percentage
points, Switzerland, with 0.3 percentage points,

13

The US energy resurgence has been swifter and stronger than expected.

and Taiwan, with an even more negligible 0.1


percentage points. The rest of the equity markets
lost market share, led by the Eurozones 5.1
percentage point decline, as shown in Exhibit16.
While many investors overinvested in emerging

markets in anticipation of higher returns and a


growing share of world equity indexes, the share
of emerging market equities dropped by 0.4
percentage points over this period.
Does this outperformance by US equities reflect
improving fundamentals of the corporate sector or
an overvaluation of US equities?

Exhibit16: Global Market Share

US equities now account for more than half of the global market.
Weight
United States
United Kingdom
Japan
Canada
France
Switzerland
Germany
Australia
China
Korea
Taiwan
Spain
Brazil
India
Russia
Eurozone
EM

Current
52.4%
7.1%
7.2%
3.6%
3.3%
3.1%
3.1%
2.5%
2.3%
1.5%
1.3%
1.2%
0.9%
0.7%
0.3%
10.2%
10.3%

Change vs. 2007


9.7%
-2.7%
-1.6%
-0.2%
-1.2%
0.3%
-0.6%
-0.4%
0.4%
-0.1%
0.1%
-0.6%
-0.4%

-0.6%
-5.1%
-0.4%

Data as of December 31, 2014.


Note: Based on MSCI All Country World Index weghts. Showing changes relative to October 9, 2007.
Source: Investment Strategy Group, Datastream, MSCI.

14

Goldman Sachs january 2015

Earnings: The superior performance of US


companies goes beyond topline returns and can be
seen across several metrics, starting with earnings
per share. Earnings per share in the United States
have increased significantly from their 2009 trough
and their pre-crisis peak in the third quarter
of 2007, as shown in Exhibit17. In contrast,
corporate earnings in the Eurozone are well below
their pre-crisis peak. In Japan, earnings are about
the same level as in the third quarter of 2007.
On the surface, earnings growth in emerging
markets has slightly outpaced that of the United
States. However, US companies have enjoyed a
steady increase in earnings from the trough of
the crisis while emerging market equities have
remained basically flat for the last 3.5 years and
are below their 2011 peak levels. We also note
that Chinas financial sector accounts for all of this
slight outperformance. As shown in Exhibit17,

Exhibit17: Earnings-per-Share Growth

Exhibit18: Share of State-Owned Enterprises in


Countries Top 10 Companies

US earnings are above their pre-crisis peak.

Chinas involvement in the largest companies is the highest


of any country.
10/31/2007 = 100
250

Share
100%

US
Eurozone
Japan
EM
China
China Ex-Financials

200
150

96

90%

81

80%
70%

59

60%

50

50%
100

48

40%

Jun-09

Apr-10

Feb-11

Dec-11

Oct-12

Aug-13

Jun-14

Austria

Belgium

Greece

France

Ireland

Norway

India

South Korea

Aug-08

Brazil

China

0%
Russia

-50
Oct-07

10

0
UK

Spain

15

Germany

16

10%

US

17

20%

Italy

30%
50

Data through November 2014.


Source: Investment Strategy Group, Datastream.

Data as of 2013.
Note: Showing an equally weighted average of SOE shares of sales, assets and market values among
countrys top ten companies.
Source: Investment Strategy Group, OECD.

the earnings-per-share growth of Chinese stocks


excluding the financial sector has underperformed
that of US equities.
Chinese earnings warrant further examination.
While MSCI China represents only 2.3% of global
market capitalization, up from 1.9% in late 2007,
earnings per share have doubled. Yet, despite
such an increase in earnings, Chinese equities
have lagged US equities by 65%. In other words,
valuations of Chinese equities, as measured by
price-to-trailing earnings or price-to-book value,
have decreased by around 70%. Furthermore,
while the corporate sector in most developed
economies has been reducing financial leverage,
Chinese companies have been adding to it, with
financial leverage (as measured by assets divided by
shareholder equity) rising to 10.3 times, compared
with 4.5 for US companies. So the increase in
earnings has been driven by an unsustainable pace

of borrowing. Leverage in Chinas financial sector


has also risen to 14.1 times. Hence, investors are
demanding a significant risk premium for owning
Chinese equitiesand rightfully so, in our opinion.
We believe that this widening of the risk
premium required to hold Chinese equities relative
to US equities will persist. The financial sector
accounts for 42% of MSCI China, leaving a sizable
portion of Chinas stock market reliant on earnings
of uncertain sustainability. To put this number in
perspective, the 42% weight of the financial sector
in Chinese equities is nearly double the 22% share
of the financial sector in US equities in the months
before the global financial crisis. It also exceeds the
technology sectors 34% share of US equities at the
peak of the technology bubble.
We also believe that investors have been
adversely affected by the heavy hand of the state
in running Chinas private sector companies.
As shown in Exhibit18, Chinas
involvement in the 10 largest companies
is the highest of any country and
very high even by emerging market
standards, based on measures
maintained by the Organisation
for Economic Co-operation and
Development (OECD).

The superior performance of


US companies goes beyond
topline returns.

Outlook

Investment Strategy Group

15

Exhibit19: Financial Leverage of Listed Companies

Exhibit20: Working Age Population Projections

US companies use the lowest amount of debt.

The US enjoys favorable demographics.

US
Japan
Emerging Markets
Eurozone
China

As of Q3 2014
4.5
5.7
6.1
8.1
10.3

Change vs. Q4 2007


-0.6
0.1
1.2
-1.5
2.0

Data as of Q3 2014.
Note: Financial leverage measured as assets divided by shareholder equity.
Source: Investment Strategy Group, Datastream.

2007=100

US
China
Russia

160

Eurozone
Brazil

Japan
India

140
120
100
80
60

The use of leverage has been a consistent theme


across emerging markets. Examining the underlying
components that contribute to earnings, we see that
the return on equity (ROE) of emerging market
equities has declined by a noteworthy 6.3 percentage
points since late 2007 while the financial leverage
ratio of emerging market companies has increased
by 1.1. In the United States, ROE has decreased by
1.4 percentage points, but the corporate sector has
achieved this return while cutting back on financial
leverage. (See Section III on the divergence of ROEs
across different regions.)

40
2007

2016

2043

2052

2061

2070

2079

2088

2097

When it comes to the quality of corporate


earnings, the United States has outpaced the
Eurozone, Japan and emerging markets, with
the highest ROE yet the lowest levels of financial
leverage, as shown in Exhibit19.

The US continues to attract innovators from all over the world.

Data through 2010.


Note: Showing the number of inventors migrating to the United States between 2001 and 2010.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, World Intellectual Property Organization.

Goldman Sachs january 2015

2034

Data projected through 2100.


Source: Investment Strategy Group, United Nations Population Division.

Exhibit21: Migration Flows of Inventors to the US

16

2025

Exhibit22: Government Support for R&D

Exhibit23: Labor Productivity

US businesses benefit greatly from direct and indirect backing.

The US remains substantially more productive than its peers.

Business Enterprise
R&D (% GDP)

US = 100

R&D Tax Incentives:


US$ 75 million

US$ 250 million

US$ 2,500 million

100

3.5%

90
80

3.0%

70

KOR

2.5%
JPN

2.0%

60
50

AUT

40

United States

France

Taiwan

Spain

Italy

Belgium

0.45%

United Kingdom

0.35%

Total government support (direct and tax) to business R&D (% GDP)

Germany

0.25%

RUS

BRA
0.15%

10
Japan

0.0%
0.05%

CAN

Russia

TUR

20

FRA

South Korea

PRT

IRL

Mexico

0.5%

ESP

BEL

Brazil

CHN

30

USA

India

1.0%

GBR NLD

China

AUS

1.5%

Data as of 2011.
Source: Investment Strategy Group, OECD.

Data as of 2013.
Note: Based on PPP GDP per worker.
Source: Investment Strategy Group, The Conference Board Total Economy Database.

Widening Gap across Human Capital Factors

accounting for 30% of world R&D and exceeding


the next-highest spender, China, by 55%.11 The
US economy benefits from the strong direct and
indirect support that its government provides for
business R&D, as shown in Exhibit22. The United
States has also accounted for more than two-thirds
of venture capital funds available to invest in new
ideas and technology since 2007.12 US technology
companies now account for 65% of the market
capitalization of global technology companies. This
stake surpasses the US overall 52% share of global
market capitalization and far exceeds the 36% share
of the number of US technology companies as a
percentage of the global total of such companies.13
As Professor Dale Jorgenson of Harvard
University has so often stated, productivity growth
is the key economic indicator of innovation.14
On this measure too, the United States has
outperformed other developed markets. Since the
end of 2007, US labor productivity has increased
by an annual average rate of 1.2%, compared with
an increase of 0.3% in the Eurozone and 0.5% in
Japan. This is a noteworthy achievement, given
that the United States already ranked highest in
labor productivity in 2007 among key developed
and emerging market countries and regions. And as
of 2013, the latest year for which comprehensive
data are available, the United States remains
substantially more productive than the Eurozone,
Japan and all emerging market countries, as shown
in Exhibit23.

Human Capital Advantages: In past reports, we


highlighted the human capital advantages of
the United States with respect to demographics
including immigration, the quality of higher
education and the brain gain from the rest of the
world. These advantages persist.
For example, the working age population
in the United States has grown by 4.7% since
2007, exceeding growth rates (or declines) of the
Eurozone, Japan, China and Russia. Only India
and Brazil have posted stronger growth, as shown
in Exhibit20.
Meanwhile, the brain gain from all over the world
continues, as illustrated by Exhibit21. In fact, a study
by the World Intellectual Property Organization
shows that the pace of highly skilled inventor
immigration has picked up momentum, with flows
to the United States increasing by 51% between the
200105 and the 200610 periods.10 The flip side of
this trend is steady emigration from other countries.
China has experienced the largest brain drain, with
an increase of 65% between these two periods.
Productivity and Manufacturing Cost Advantage:
The United States has been the center of
technological innovation in the world for some time,
and this advantage held firm in 2014. The OECD
estimates the United States spent about $400 billion
on research and development (R&D) in 2012,

Outlook

Investment Strategy Group

17

The US ranks among the top countries for labor productivity and cost-competitive manufacturing.

An April 2014 analysis by the Boston


Consulting Group (BCG) shows that the only
country among the worlds 10 largest exporters
with a cost-competitive advantage over the US is
China, as shown in Exhibit24. That said, with
the exception of the Netherlands, all countries
have actually lost ground relative to the US over
the last 10 years. Even China will continue to
see its manufacturing competitiveness erode.
If both countries maintain the same change in
components of manufacturing costs, including
productivity changes, as they have over the last 10
years, BCG estimates that China will actually be
less competitive than the US by 2018. Such a shift
would improve the competitiveness of US exports
in very short order.
Is the Widening Gap Cyclical or Structural?

Some have suggested that this widening gap


between the United States and other developed
and emerging market countries is cyclical and
the United States has simply recovered faster.
While there are some cyclical components to this
widening gap, we believe that the differences are
primarily structural.
As outlined in past Outlooks and touched
upon here, the United States has major structural
advantages over other key countries and regions,

18

Goldman Sachs january 2015

including favorable demographics, immigration,


productivity, economic diversity and wealth of
resources. The United States also has a resilience
and responsiveness that stands out and takes
many forms. For example, US monetary policy has
been aggressive and decisive in trying to stimulate
economic activity since the financial crisis, while
that of Europe and Japan has been incremental
and hesitant. US regulators implemented bank
stress tests earlier and more rigorously than their
counterparts in the Eurozone.
While it is fashionable to complain about
dysfunction in Washington, DC, the United States
dealt with its major structural fault lineits
debt profilein a relatively short period of time,
through several key pieces of legislation including
the Budget Control Act, the American Taxpayer
Relief Act and other discretionary spending cuts
to implement fiscal reform in the aftermath of the
global financial crisis.
The corporate sector also restructured rapidly,
allowing for a far greater number of bankruptcies,
as shown in Exhibit25. The resilience of corporate
America is probably best seen through the prism
of two rankings: the United States ranks number
one in the Index of Economic Freedom15 and the
Ease of Doing Business16 among all countries
with world GDP share above 2.5% and world

Exhibit24: Average Manufacturing Costs

Exhibit25: Corporate Bankruptcies

Only China retains a cost-competitive advantage over the US.

US corporates have restructured more rapidly.

US = 100

Q1 2006 = 100

130

390

125

Higher costs

120

121.1

115
108.6

110
105
100
95

100.0

111.0

122.7

123.3

124.3

US
Germany
France
UK
Japan

340

111.5

290
240

102.4

95.5

190

90

140

85
France

Belgium

Italy

Germany

Netherlands

Japan

UK

South Korea

US

China

80

Data as of 2014.
Source: Investment Strategy Group, BCG.

90
40
2006

2007

2008

2009

2010

2011

2012

2013

Data through Q3 2013.


Source: Investment Strategy Group, OECD.

population share above 0.5%. The United States


encourages entrepreneurship and innovation
while allowing companies to fail or restructure, a
key underpinning of US productivity growth and
competitiveness.
Given our view that this widening gap is mostly
due to the structural advantages of the United
States, it follows that US preeminence will endure.

not only by our view of US preeminence, but


also by the nations deeper capital markets,
greater liquidity and generally better corporate
governance. For clients who place value on capital
preservation, we believe the US offers the best longterm, risk-adjusted returns.
As of December 2014, a typical moderate-risk
model portfolio for US clients would have 63% of
its strategic equity allocation in US public equities,
well above their market capitalization weight of
Investment Implications of
52%. Similarly, a moderate-risk model portfolio
the Widening Gap
for non-US clients with a euro-perspective would
have 57% of their strategic allocation to equities
The investment implications of the widening of
in the United States. Most of our clients hedge
the gap between the United States and the key
fund and private equity assets will inevitably
developed and emerging market countries and
have a US orientation as well, given the greater
regions are twofold: strategic and tactical.
allocation of most hedge funds and private equity
funds to US assets.
Strategic Implications
A question that often arises is why not allocate
From a strategic asset allocation perspective, we
all assets to the United States? There are two
recommend maintaining an overweight to US
compelling reasons. First, diversification is a key
equities relative to their share of global market
pillar of our investment philosophy, as shown
capitalization. This recommendation is driven
in Exhibit26. No one has a crystal ball that can
consistently predict when US assets will
or will not outperform non-US assets.
US preeminence does not mean that
US preeminence does not mean that
US assets will always outperform. In
fact, there are many periods in which
US assets will always outperform.
US equities have underperformed the
Eurozone, Japan and emerging market
equities by significant amounts and

Outlook

Investment Strategy Group

19

over long periods of time for varying reasons. For


example, between 2002 and early 2008, MSCI
EAFE (Europe, Australasia, Far East) outperformed
the S&P 500 Index by nearly 90%, or about 9% a
year for over six years, after a similarly long period
of US outperformance (see Exhibit27). Much of
the outperformance was due to stronger currencies
in EAFE countries during this period.
Second, valuation, another key pillar of our
investment philosophy, does not favor US equities
relative to those of the Eurozone and Japan at this
time, hence our tactical tilts, which are discussed in
greater detail below.
Tactical Tilt Implications

Monetary Policy, Interest Rates and the Dollar:


We believe monetary policy will be a key driver
of the performance of financial assets in 2015.
The widening gap in expected growth trajectories
between the United States and the Eurozone and
Japan increases the likelihood that the Federal
Reserve will start to tighten monetary policy in
2015 while the European Central Bank (ECB)
and the Bank of Japan (BOJ) are expected to
ease monetary policy further. This divergence
of policy has implications for our tactical tilts
toward the dollar.

There is considerable debate as to when and


at what pace the Federal Reserve will start to
tighten rates. As we put forth our view of the likely
path of Federal Reserve policy, we are reminded
of a Fall 2014 interview in McKinsey Quarterly
with Robert Solow, the macroeconomist, Institute
Professor emeritus at the Massachusetts Institute
of Technology and Nobel laureate. He said as
an ordinary macroeconomist, I have avoided
forecasting as if it were a foul diseaseas indeed it
is. Its very damaging to the tissues.17 Nevertheless,
we can share some thoughts about the likely path
of Federal Reserve policy. Here, we let the words of
French mathematician Jules Henri Poincar egg us
on as they did last year: It is far better to foresee
even without certainty than not to foresee at all.18
In our base case scenario, the Federal Reserve
will start hiking the federal funds rate at the July
2015 meeting. We expect a somewhat moderate
path for 2015, with rates rising by a total of 75
basis points by the end of the year. We believe the
Federal Reserve will raise rates at a slower pace
than is typical of the last several rate-hike cycles.
Policymakers remain unsure whether this postfinancial crisis recovery has created structural
underemployment and permanently lowered
the labor participation rate, therefore leading to
uncertainty about the level of slack in the economy.

Exhibit26: Pillars of the ISGs Investment Philosophy


Exhibit 9: Pillars of the Investment Strategy Groups Investment Philosophy
INVESTMENT STRATEGY GROUP

History Is a
Useful Guide

Appropriate
Diversification

Value
Orientation

Appropriate
Horizon

Consistency

ANALYTICAL RIGOR
ASSET ALLOCATION PROCESS IS CLIENT-TAILORED AND INDEPENDENT OF IMPLEMENTATION VEHICLES

20

Goldman Sachs january 2015

Exhibit27: US vs EAFE Equities

Exhibit28: Federal Funds Rate Paths

US equities have had bouts of underperformance that can


last years.

We expect the Federal Reserve to start hiking rates in July.


4.5%

Ratio
1.4
1.2

ISG View
GIR View

4.0%
1.23

1.18

1.23

US Outperforms

Market Implied
3.5%

Median FOMC Projection

3.0%
1.0
2.5%
0.8

2.0%
1.5%

0.6

1.0%
0.4

0.5%

0.2
1970

1974

1978

1982

1986

1990

1994

1998

2002

2006

2010

2014

0.0%
Dec-14

Dec-15

Dec-16

Dec-17

Dec-18

Data as of December 31, 2014.


Note: Based on MSCI US and MSCI EAFE US$ total return indexes. Blue shaded areas denote periods
of US underperformance relative to EAFE.
Source: Investment Strategy Group, Datastream.

Data as of December 31, 2014.


Note: For informational purposes only. There can be no assurance that the forecasts will be achieved.
Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research,
Federal Reserve.

Since WWII, the average pace of interest rate


hikes has been about 300 basis points a year over
a tightening cycle, but this average includes the
periods of high inflation in the mid-to-late 1970s
and early 1980s. Excluding these periods, the
average rate hike pace is about 200 basis points a
year. The slowest pace occurred between 1954 and
1957, when the Federal Reserve hiked rates about
85 basis points a year. As shown in Exhibit28,
we expect a pace of about 100 basis points a year
on average for 3.5 years, which is in line with the
view of our colleagues in Goldman Sachs Global
Investment Researchs economics research team.
Of course, as Federal Reserve Chair Janet
Yellen has said on multiple occasions, policy
will be determined by the most current and most
comprehensive set of data, including leading
indicators, growth, housing, unemployment and
inflation.
Still, in the past, the Federal Reserve has
underestimated the pace at which it acted to
normalize rates. This underestimation was most
pronounced in 1994, when the Federal Reserves
policy projections were 190 basis points below
where rates eventually landed one year later.
Interestingly, in this cycle, the Federal Reserves
projections are substantially above the path
implied by the markets as well as our view, as
shown in Exhibit28.

Exhibit29: 2015 Treasury Return Projections

Outlook

Investment Strategy Group

We expect modest negative returns across Treasury


maturities.
0.5%
0.3%
0.0%
-0.1%
-0.5%

-1.0%
-1.3%

-1.5%

-1.7%
-2.0%
Cash
(3-Month)

2-Year Treasury

5-Year Treasury

10-Year Treasury

Data as of December 31, 2014.


Note: For informational purposes only. There can be no assurance that the forecasts will be achieved.
Source: Investment Strategy Group, Bloomberg.

Underweight Investment-Grade Bonds, Overweight


High-Yield Bonds: A rising interest rate policy in
the face of 3% GDP growth and core consumer
price index inflation nearing 2% is likely to
lead to higher interest rates across fixed income
securities, resulting in a negative return in the
fixed income markets. As shown in Exhibit29, we
expect modest negative returns across a range of

21

Exhibit30: US Dollar Index

Exhibit31: Central Bank Balance Sheets

We expect less appreciation now than in previous dollar


strength cycles.

Diverging monetary policies support the US dollar.

DXY

% GDP

170

100%

160

90%

150

+93%

80%

140

Forecast
Federal Reserve
ECB
BOJ

91%

70%

130

60%

120

50%

+46%

110

40%

100

30%

90
80

20%

70

10%

27%
19%

0%

60
1973

1978

1983

1988

1993

1998

2003

2008

2013

Data as of December 31, 2014.


Source: Investment Strategy Group, Datastream.

Treasury maturities in 2015. We recommend clients


underweight investment-grade bonds both on an
absolute basis and relative to other alternatives.
As we did last year, we recommend an
overweight to high-yield bonds and bank loans.
We expect both sectors to outperform investmentgrade bonds and cash in 2015. High-yield spreads
have widened significantly since mid-June 2014
as a result of the decline in oil prices and growing
concerns about defaults in the high-yield energy
sector. We do not expect default rates to reach
levels priced by the market and believe that these
higher incremental yield levels provide an attractive
risk/return opportunity.

2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016
Data forecast through end of 2016.
Note: ISG forecasts of central bank balance sheets. IMF forecasts of nominal GDP.
Source: Investment Strategy Group, Datastream, IMF.

Overweight the Dollar: The divergence in growth


rates between the United States and the Eurozone
and Japan, the resulting divergence in monetary
policy and renewed recognition of US preeminence
are likely to lead to an increase in the value of the
dollar relative to the euro and the yen.
We believe that this cycle of dollar appreciation
is more akin to the 197885 and 19952002
periods of dollar strength. As shown in Exhibit30,
during these two periods, spanning 6.3 years and
6.8 years, the dollar appreciated 93% and 46% on
a trade-weighted basis, respectively. In these periods,
the primary driver of the dollars strength was the
divergence of monetary policy. We expect the dollar
to appreciate an incremental 10% or so relative to
the euro and the yen over
the course of 2015.
We are not projecting
a higher level of dollar
appreciation because we
are not expecting large
interest-rate differentials
between Treasury securities
and German Bunds and
Japanese government
bonds. Furthermore, the
US dollar has already
risen 24% from its trough
in April 2011. The most
recent appreciation
We expect the dollar to appreciate further relative to the euro and the Japanese yen in 2015.

22

Goldman Sachs january 2015

Exhibit32: US Equity Price Returns from Each


Valuation Decile

Exhibit33: Dispersion of US Equity Returns in the


9th Valuation Decile

We expect moderate returns at current valuations.

The average returns belie great dispersion.

%ann.

5Y Annualized Price Return


% Observations with Positive Returns (right)

14%
12%

13%

90%

11%

80%
10%

10%

200%

Current
Decile

8%

8%

7%

6%

6%

6%

7%

176%

100%
150%

70%
60%

100%

50%
40%

5%

50%

30%

4%

20%

2%
0.4%

10%

5%
0%

0%

0%
1

Less Expensive

Valuation

10

More Expensive

-50%

-33%
Lowest Cumulative Price
Return Over 5 Years

Average Annualized 5-Year


Price Return

Highest Cumulative Price


Return Over 5 Years

Data as of December 31, 2014


Note: Based on five valuation metrics for the S&P 500, beginning in September 1945: price-to-trend
earnings, price-to-peak earnings, price-to-trailing 12m earnings, Shiller cyclically adjusted price-toearnings ratio (CAPE) and price-to-10-year average earnings. These metrics are ranked from least
expensive to most expensive and divided into 10 valuation buckets (deciles). The subsequent realized,
annualized five-year price return is then calculated for each observation and averaged within each decile.
Past performance is not indicative of future results.
Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg, Datastream, Robert Shiller.

followed statements by ECB President Mario Draghi


in November 2014 suggesting more significant
measures to prevent the Eurozone from sliding into
deflation and by BOJ Governor Haruhiko Kuroda
in late October 2014 to increase Japans pace of
quantitative easing to fight deflation. This divergence
of monetary policy can also be seen in the projected
balance sheets of the three central banks over the
next two years, as shown in Exhibit31.
The corollary to our view on US preeminence
and a strong dollar is a negative view on gold. The
correlation between gold and the dollar has been
-0.36 since 1974. Even though gold has already
declined almost 40% from peak levels in September
2011, we believe that gold prices have further
downside given declining physical demand, a stronger
dollar and rising US interest rates. We recommend
a tactical allocation that is designed to benefit from
declining gold prices with some downside protection.

the six-plus years of US equities outperformance


have already discounted much of the US cyclical
recovery and US structural preeminence.
Our clients are familiar with our preferred
valuation approach for US equities. We use a
composite of five valuation metrics since 1945:
price-to-trend earnings, price-to-peak earnings,
price-to-trailing 12-month earnings, Shiller CAPE
and price-to-10-year average earnings.
Based on this composite measure, we
acknowledge that US equities are expensive, just
as we did in last years Outlook, Within Sight of
the Summit. As shown in Exhibit32, equities rank
in the 9th decile of valuations, meaning equities
have been more expensive based on this aggregate
measure only 10% of the time in the post-WWII
period. While some would suggest underweighting
equities at this decile, we note that annualized fiveyear price returns from this decile have averaged 5%
and have been positive 63% of the time. Moreover,
we have been in this decile since November 2013
and the S&P 500 has returned 21% over the period,
partly driven by earnings growth. We repeat our
recommendation to stay fully invested in US equities.
We expect some volatility. As shown in
Exhibit33, there is significant dispersion of returns
in the 9th decile. Furthermore, the probability of

Stay Fully Invested in US Equities: Given our view of


the widening gap between the United States and key
countries and regions, one might expect a tactical
overweight to US equities. While we recommend
an above-market capitalization weight strategically,
we also recommend that clients not exceed the full
strategic allocation at this time. As mentioned earlier,

Outlook

Investment Strategy Group

23

Exhibit34: Probability of Loss in the S&P 500 When


Valuations Are High

We recommend that clients be prepared for downdrafts.


Probability of Loss
100%

100%

90%
80%
70%

62%

60%
50%

40%

40%
30%

26%

20%
10%
0%
-5%

-10%

-15%

-20%

Magnitude of Loss
Data as of December 2014.
Note: Showing peak-to-trough losses within a year. Based on data since 1945 and conditional on being
in the 9th or 10th aggregate decile at the beginning of the one-year rolling window.
Source: Investment Strategy Group, Bloomberg.

loss is much greater at higher valuation levels,


as shown in Exhibit34. If we define a loss as a
peak-to-trough downdraft during the year, the
probability of a 5% loss is 100% within the 9th or
10th deciles; the probability of a 10% loss is 62%.
So while we recommend clients stay fully invested
in US equities, we also recommend that clients be
prepared for bouts of volatility and downdrafts.
We maintain a tactical tilt toward US banks.
This tilt has been in place since December 2010
and has returned about 52% since then, as
measured by the S&P Banks Select Industry Index.
Valuations continue to be attractive in this sector,
given that price-to-book value has been higher
62% of the time, and book-value growth has been
accelerating after a slump in late 2013.
We are monitoring the energy sector carefully.
Given the near-term uncertainty in oil prices
and risk of further downside in oil prices and oil
stocks, we recommend a tactical tilt that provides
exposure to energy stocks with some downside
protection.
Overweight Spanish and Japanese Equities:
Whereas US equities are expensive, EAFE equities
in general, and Eurozone and Japanese ones in
particular, are trading at a significant discount to
US equities.

24

Goldman Sachs january 2015

Within the Eurozone, we specifically favor


Spanish equities but are concerned about the
downside in French ones. Spains economy is
growing faster than that of France, and leading
indicators suggest this trend should continue.
Spanish companies are also benefiting from labor
reforms that have lowered their unit labor costs,
while French companies face rising unit labor
costs in the absence of meaningful labor reforms.
In the BCG study referenced above, France ranks
second-to-last among 25 countries with respect
to its manufacturing cost competitiveness, and
substantially lower than Spain. We believe that
the above factors, combined with divergent
manufacturing cost competitiveness, are not
accurately reflected in valuations: Spanish equities
trade at a significant discount to French equities
relative to the long-term average discount between
the two.
We also like Japanese equities. They have
performed well following major policy moves,
and we have seen a number of positive policy
announcements in recent months. As mentioned
earlier, the BOJ has increased the size and
breadth of its quantitative easing program. The
Government Pension Investment Fund has also
announced a shift in its asset allocation toward
domestic and international equities. Both moves
provide some meaningful upside to Japanese
equities.
Emerging Markets: Since reducing our strategic
allocation to emerging market debt, equities and
private equity in June 2013, we have maintained a
neutral view of emerging markets. We believe that
most of these countries face deteriorating growth
prospects and uncertain geopolitical risks, and
yet the markets are not taking these factors into
account. In aggregate, emerging market equities are
trading at only a slight discount to their long-term
averages. Even Russian valuations are only 0.9
standard deviation below their long-term average.
We therefore recommend that clients reassess their
strategic allocation to emerging markets in light
of the deep structural fault lines (detailed in our
December 2013 Insight report, Emerging Markets:
As the Tide Goes Out), the deteriorating economic
backdrop, and a rising interest rate environment in
the United States that could reduce capital flows to
these countries.

Exhibit35: ISG Prospective Returns

Expected returns over the next one and five years are below historical realized averages.
18%
2015 Expected Return

16%

5-Year Prospective Annualized Return

15

14%

12

12%

11

10%
8%

4%
1

2%

0%
-2%

6%

-2

13

13

12
10

10

9
7

-1

-4%
10-Year
Treasuries

Muni
1-10

US
Cash

Emerging
Market
Local Debt

S&P 500

Emerging
Market Equity

Hedge
Funds

US High
Yield

Bank
Loans

Euro
Stoxx 50

UK
Equity

EAFE
Equity

US
Banks

Japanese
Equity

Data as of December 31, 2014.


Note: For informational purposes only. There can be no assurance that the forecasts will be achieved.
Source: Investment Strategy Group. See endnote 19 for list of indexes used.

Prospective Returns

Our total return outlook is summarized in


Exhibit35.19 As we have done over the last two
years, we now provide our one- and five-year
expected returns. We expect negligible returns
in cash and high-quality bonds, modest singledigit returns in US equities and more attractive
returns in European and Japanese equities.
Emerging market expected returns are modest and
unattractive on a risk-adjusted basis. In line with
our views last year, we continue to expect very
modest single-digit returns in hedge funds.

the next one and five years are below historical


averages. At present, we see five risks extending
beyond the usual volatility of markets:
Federal Reserve tightening is more disruptive to
financial markets than we expect.
Rise of populism in Europe delays much-needed
reforms and leads to policy mistakes.
Russian adventurism extends beyond Ukraine.
Geopolitical hotspots of 2014 go unextinguished.
Ebola epidemic spreads beyond West Africa.

Before we review each of these risks, we take


stock of the low-probability risks outlined in our
The Risks to Our Investment Views
2014 Outlook to see if any of them materialized or
should influence our thinking for 2015.
Investment returns without some level of risk are
Last year, we called out six risks but labeled
hard to come by; this is especially true in a lowthem as low-probability. Some materialized and
return environment in which expected returns over
some did not: the US did not stall into recession;
the exit from quantitative easing was a
non-event (and will factor into our risk
assessment of Federal Reserve tightening
We see five risks extending beyond
in 2015); the Eurozone sovereign debt
crisis did not bubble over; confidence
the usual volatility of markets.
in Japans Three Arrows was eroded
and the tax hike was detrimental to
growth; one emerging market country,
Russia, experienced a hard landing; and
geopolitical hotspots resulted in military

Outlook

Investment Strategy Group

25

Exhibit36: Sequence of Federal Reserve Tightening,


S&P 500 Peaks and Recessions

Tightening does not impact US markets or the economy in a


predictable manner.

Exhibit37: Measures of US Joblessness

The true level of unemployment is uncertain.


Unemployment
Rate (sa)
20%

Beginning of
Fed Tightening

S&P 500
Peak

Recession
Begins

U-3 (Official)
U-6 (Broadest)

18%
16%
14%
12%

11.4

10%

Average: +18 Months


Median: +14 Months
Shortest: +1 Month
Longest: +42 Months

Average: +10 Months


Median: +9 Months
Shortest: +1 Month
Longest: +30 Months

8%
6%

5.8

4%
2%
0%

Average: +28 Months


Median: +30 Months

Shortest: +11 Months


Longest: +43 Months

Data as of December 2014.


Note: Based on 8 historical tightening cycles that led to recession.
Source: Investment Strategy Group.

engagement. Importantly, none of the realized risks


derailed the US economy or slowed down the rise
of US equities.
We are not carrying all these risks into 2015.
As discussed earlier, the US economy is on a strong
footing and has gained momentum, recovering
from a surprisingly weak first quarter. While
confidence in some aspects of Prime Minister
Shinzo Abes Three Arrows intended to boost
Japans economy and combat deflation has
dissipated, confidence in the impact of the BOJs
aggressive monetary policy has increased.
China may be viewed as being at risk of a hard
economic landing, but we see this as unlikely.
We expect Chinas leadership to pursue the same
policies they did in 2014 to avert a significant
slowdown. China certainly has enough resources
and reasons to prevent a hard landing.
Risks related to Federal Reserve tightening,
along with political and geopolitical risks, may
challenge our 2015 outlook.
Federal Reserve Tightening

The greatest risk to the US economy, and hence to


our clients portfolios, is a disorderly start to the
Federal Reserves normalization of interest rates.
However, we think this is a low-probability risk.

26

Goldman Sachs january 2015

2007

2008

2009

2010

2011

2012

2013

2014

Data through November 2014.


Note: U-3 is the official unemployment rate. U-6 includes total unemployed plus all persons marginally
attached to the labor force plus total employed part time for economic reasons, as a percentage of the
civilian labor force plus all persons marginally attached to the labor force.
Source: Investment Strategy Group, Datastream.

While we cannot rule out some volatility in US


financial assets in response to the first few interest
rate hikes, we do not think that the normalization
of policy will negatively impact US equities and/or
lead to a recession in 2015.
We should quickly dispel the notion that
every tightening leads to recession. In the United
States, there have been 14 tightening cycles in the
post-WWII period. Of those cycles, eight led to
recessions and six did not. Of those eight that did
lead to recessions, two coincided with oil shocks
in the 1970s that emanated from the Arab oil
embargo, the Iranian revolution and the Iran-Iraq
War. And not every recession in the United States
was caused by tightening of Federal Reserve policy.
In those tightening cycles that led to a recession
and a downdraft in US equities, the average
lead time from the first rate hike to the onset of
recession was 28 months and the median was 30
months, as shown in Exhibit36. One recession
occurred within 11 months and one occurred
3.6 years following the first rate hike. In this set
of tightening episodes, the S&P 500 peaked, on
average, within 18 months of the first rate hike,
and the median was 14 months; however, one S&P
500 peak occurred within one month and one
occurred as much as 3.5 years later. We provide this

level of detail because we think it is very important


that our clients know that not every tightening
leads to a recession, let alone leads to a recession
in any predictable manner. The level of inflation
and unemployment, the output gap as a measure of
slack in the economy, external shocks and the pace
of tightening all have some bearing on the impact
of policy tightening.
Our base case scenario is that the normalization
of policy will not be disruptive to US financial
markets and/or the US economy in any meaningful
way. First, we look at the impact of tapering when
former Federal Reserve Chairman Ben Bernanke
initially mentioned it in May 2013. While US
equities dropped 5% from peak to trough, they
recovered fully by early September. Bonds had a
more negative reaction, with 10-year Treasury
prices dropping 7% over the following three
months. However, since then US interest rates have
steadily declined. Other factors had much greater
impact on the US economy, interest rates and
equities.
In addition, a quantitative analysis of S&P
500 volatility shows that volatility tends to
decline for about three months after the start of
policy tightening, after which the effect dissipates.
Surprisingly, we find no evidence of systematic
directional changes in bond volatility.
Second, we think that the Federal Reserve will
be particularly cautious about the normalization
of monetary policy. As shown in Exhibit37,
there is some uncertainty about the true level of
unemployment. There are six alternative measures
of unemployment, each trying to capture a different
dimension of labor underutilization. For example,
there are persons who are marginally attached
to the labor force but who, when asked, say they
would like to be employed. They are captured in
the broadest unemployment rate, known as U-6.

Disorderly Federal Reserve tightening is the greatest risk in 2015.

By way of illustration, U-6 is at 11.4% while the


more widely used unemployment rate, U-3, stands
at 5.8%.
No one can be certain about the actual level
of slack in the labor market; hence some level of
caution is prudent with respect to monetary policy
tightening, given that full employment is one of
the Federal Reserves two mandates. At the August
2014 economic symposium in Jackson Hole, Wyo.,
Federal Reserve Chair Janet Yellen stated: Over
the past year, the unemployment rate has fallen
considerably, and at a surprisingly rapid pace. The
developments are encouraging, but it speaks to the
depth of the damage that, five years after the end
of the recession, the labor market has yet to fully
recover.20
Inflation is also very low, giving
Federal Reserve officials flexibility to
raise rates more slowly. As shown in
We should quickly dispel the notion
Exhibit38, both the core and headline
personal consumption expenditure
that every tightening leads to
indexes are historically low, with
recession.
core inflation well below the Federal
Reserves target of 2%. Lower oil
prices, excess capacity on a global
basis, disinflationary pressures from the

Outlook

Investment Strategy Group

27

been anemic and headline


inflation (the inflation the
ECB targets) is well below
target at 0.3%.
Given the recent
absence of market
pressures, Eurozone
leaders have become
even more complacent
about undertaking muchneeded labor reforms.
Exhibit39 illustrates the
trend in unit labor costs
across key Eurozone
countries. As mentioned
earlier, France is the
second-least competitive
country among the top 25
The National Fronts ascent in France is emblematic of rising populism in the Eurozone.
world exporters.22 In the
absence of policies that
Eurozone and Japan and an appreciating dollar
would change cost structures, France is likely to
on a trade-weighted basis all point to contained
lose further ground to world exporters. President
inflation levels for 2015.
Franois Hollandes record-low popularity rating
While we believe that the Federal Reserve
(see Exhibit40) makes it unlikely that significant
will lean on the side of caution, the Federal
reforms will take place.
Reserve is also cognizant of the fact that by most
Some Eurozone countries have pushed ahead
econometric policy rules, monetary policy is
with reform efforts, albeit with mixed results.
deemed to be too easy.
Under Prime Minister Matteo Renzi, Italy has
been more committed to reforms. He is likely to
Eurozone Crisis Is Reignited

Risks stemming from the Eurozone are twofold:


headline risks in 2015 as a result of elections in
Spain, Portugal and Greece; and risks over the next
several years as an adverse political cycle unfolds
due to slow growth and high unemployment.
From the beginning of the sovereign debt
crisis, we have characterized Eurozone policy as
incremental, inconsistent and reactive.21 For
evidence of inconsistent policy in the context of the
global economic and financial market backdrop,
we point to former ECB President Jean-Claude
Trichets decisions to hike rates in July 2008 and
twice in 2011 while the United States was lowering
rates aggressively and implementing quantitative
easing policies.
Since the global financial crisis, Eurozone
policymakers have been incremental in
implementing structural reforms that address
labor flexibility and fiscal discipline, and have
been reactive in setting up Eurozone-wide
institutional structures. As a result, growth has

28

Goldman Sachs january 2015

Exhibit38: US Core and Headline Inflation

Inflation remains at historically low levels.


%YoY
14%

Headline
Core

12%
10%
8%
6%
4%
2%
0%
-2%
1960

1966

1972

1978

1984

1990

Data through November 2014.


Note: Based on personal consumption expenditure price indexes.
Source: Investment Strategy Group, Datastream.

1996

2002

2008

2014

Exhibit39: Unit Labor Costs Across the Eurozone

Only Spain has been able to lower its unit labor costs since
the crisis.
2010 = 100
110

Exhibit40: Popularity of French Presidents from the


Start of Their Terms

Hollandes popularity is lowest among recent French


presidents.
% Polled Who
Have Confidence

Hollande (2012)
Sarkozy (2007)
Chirac (1995)
Mitterrand (1981)

80

105

70

100

60

95

50

90

40

46
41
34

30

85

Germany
France
Spain
Italy

80
75

20

15

10
0
1

70
2000

2002

2004

2006

2008

2010

2012

2014

Data through Q3 2014.


Source: Investment Strategy Group, Datastream, Eurostat.

11

13

15

17

19

21

23

25

27

29

31

Months as President
Source: Investment Strategy Group, TNS Sofres.

succeed in implementing some moderate labor


reforms and some electoral law changes that would
introduce greater political stability. Spain also has
been more effective in implementing reforms: the
country has reduced its budget deficit as a share
of GDP by nearly five percentage points since the
trough of the crisis, and it has reduced unit labor
costs by 7% since peak levels. Spain is now the
most competitive exporter among key Eurozone
countries. In 2014, Spains GDP growth is expected
to be the third-highest in the Eurozone, after
Ireland and Germany, and 2015 growth is expected
to be the second-highest, again after Ireland and in
line with Greece.

As for Greece, the country has made significant


improvements in cutting its budget deficit, yet its
debt levels are unsustainably high at 174% of GDP.
Implementing austerity to reduce Greeces budget
deficits has pushed unemployment to a high of
26%, a level not conducive to political stability. We
expect some form of debt restructuring in 2015.
So while some progress has been made in the
Eurozone in implementing structural reforms,
it has not been enough to boost growth and
reduce unemployment to pre-crisis levels. As a
result, populism is on the rise, as evidenced by
the increasing popularity of the Syriza party in
Greece, the newly formed Podemos party in Spain,
the Five Star Movement in Italy and the
National Front in France. While they
are unlikely to lead governments soon
While some progress has
for any extended period and with a
clear majority, the rise of these groups
been made in the Eurozone in
will likely obstruct labor and fiscal
implementing structural reforms,
reforms, which will, in turn, hinder
economic growth.
it has not been enough to boost
At some point in the next few
growth and reduce unemployment
years, the Eurozone crisis will likely
be reignited and policymakers will be
to pre-crisis levels.
forced to speed up the pace of reforms
or risk serious setbacks to the broader
Eurozone project. But we do not see this
as a risk for 2015.

Outlook

Investment Strategy Group

29

The Unpredictable President Vladimir Putin

We in the Investment Strategy Group rely on the


insights of external experts to formulate our views
on geopolitical risks. We reach out to experts
from prominent research groups, think tanks,
universities and former and current government
officials, both in the United States and abroad.
When it comes to analyzing the rule and actions
of Russian President Vladimir Putin, we find their
views particularly instructive.
According to the editorial board of The
New York Times, President Vladimir Putin
of Russia has shown himself to be a reckless
and unpredictable provocateur in creating the
worst conflict with the West since the Cold
War.23 Gernot Erler, the German governments
coordinator for Eastern European affairs, has also
stated that Russia has become unpredictable.24
In our March 19, 2014, client call, Dr. Anders
Aslund of the Peterson Institute for International
Economics and former economic advisor to the
Russian and Ukrainian governments discussed
President Putins long-term goals, making
comparisons to the geopolitical environment that
led to WWII. In summary, his view is that Russia
can no longer be perceived as a status-quo power.
Rather it has become a radical revisionist and
revanchist state.25 In a September 2014 Goldman
Sachs Forum publication, Professor Nicholas Burns
of the Harvard Kennedy School of Government
and Under Secretary of State for Political Affairs
between 2005 and 2008, stated that President Putin

Russias aggressive stance toward Ukraine remains a key uncertainty.

30

Goldman Sachs january 2015

is a strategic thinker . . . a more sophisticated


leader than people have given him credit for . . .
and inclined to indirection, whereby he would
stand for peace publicly while subverting Ukraine
behind the scenes.26 In our September 11, 2014,
client call, Cliff Kupchan, Eurasia Groups
Chairman and Practice Head for Eurasia, stated
that President Putin is a horrible strategist but a
great tactician.27
President Putin has made it clear that he will
not tolerate a move by countries along Russias
southern and western borders that were once part
of the former Soviet Union to shift their primary
allegiance to the European Union (EU) or join the
North Atlantic Treaty Organization (NATO). It
is therefore highly unlikely that sanctions alone
will force Russia to abandon southern and eastern
Ukraine. Since Ukraines parliament voted to drop
its nonaligned status and work toward NATO
membership in late December 2014, significant
uncertainty remains as to what President Putin
will do if a move toward NATO membership
progresses further.
Clearly, falling oil prices have only worsened
Russias economic position. The economy is
expected to contract sharply; we expect a decline
of 35% in 2015. Russian markets will be volatile:
the ruble had dropped almost 60% from its 2014
peak in early January, only to rebound 30% from
its trough in the last few days of 2014. Russian
equities have also been volatile, falling 18% from
their 2014 highs in early January and ending the
year down 16%.
Russia will be
a source of market
volatility, placing at risk
neighboring emerging
market countries, as well
as Western companies
with businesses in Russia.
A recession in Russia will
have a greater impact on
the Eurozone than on the
United States.
None of these
Russia risks impact
our investment views.
However, the fact
that President Putin is
unpredictable means that

the threat of terrorism on


US soil is not zero, ISIL
is too preoccupied with
fighting to hit United
States targets at this time.
The Iran nuclear
negotiations have been
extended to June 30, 2015,
following 10 months of
negotiations between Iran
and the P5+1 (United
States, France, United
Kingdom, Germany,
Russia and China). The
probability of a resolution
has ranged between 30%
The fighting in Iraq and Syria has exacted a steep humanitarian toll.
and 60%, according to
our external experts. We
we may all be surprised by his next move, with the
think these diplomatic discussions will continue, as
potential for a wide range of negative and positive
it is not in the parties interests to abandon them.
implications for markets.
Both the United States and Iran would like to
avoid military confrontation, especially given the
Geopolitical Risks of 2014 Spill Over into 2015
instability in Iraq, Syria, Afghanistan and Pakistan.
The geopolitical risks of 2014 that carry over into
North Korea was back in the news in 2014.
2015 are the conflict with the Islamic State of Iraq
The planned release of a new Sony movie, The
and the Levant (ISIL), the breakdown of the Iranian
Interview, about North Koreas leadership, sparked
nuclear negotiations, the uncertainty surrounding
concerns about cybersecurity and outright threats
North Koreas next move and an oil shock from
of terrorism at movie theaters in the United States,
instability in Venezuela, Nigeria and Libya.
ultimately eliciting a response from the White
The fighting in Iraq and Syria will almost
House. This episode reminded the world of North
certainly continue as President Obama has declared Koreas unpredictable leader and its nuclear
his objective is to degrade and destroy ISIL.28
capability. Richard Haass, the president of the
Combined with the rest of the civil war in Syria,
Council on Foreign Relations, warned recently that
the fighting has exacted a steep humanitarian
it is only a matter of time before North Korea can
toll. However, the conflict in the region has had a
place a nuclear warhead on . . . missiles capable
limited impact on global economies and financial
of reaching the US.29 There are also signs that
markets. Our external experts believe that while
China is concerned about North Koreas unreliable
behavior.30 While our base case remains
that North Korea will continue to
garner headlines, we do not expect any
President Vladimir Putin of Russia
meaningful military engagement with its
neighbors or the United States.
has shown himself to be a reckless
Another low-probability risk is that
and unpredictable provocateur in
of an oil supply shock from Venezuela,
Nigeria or Libya. While the current level of
creating the worst conflict with the
oil prices and the excess supply are likely to
West since the Cold War.23
persist in the first half of 2015, we cannot
rule out supply disruptions. As some in

The New York Times
the oil industry say of their business, the
biggest surprise is no surprise.

Outlook

Investment Strategy Group

31

While the current level of oil prices


and the excess supply are likely to
persist in the first half of 2015, we
cannot rule out supply disruptions.

Strikes by Venezuelan oil workers in November


2002 pushed production down by 2.4 million
barrels per day in just two months, close to
the 2.5 million barrels per day the nation now
produces. In Nigeria, civil strife, theft and
terrorist attacks have led to supply disruptions
as large as 0.7 million barrels per day; Nigeria
currently produces just over 2 million barrels per
day. In Libya, production has already dropped
significantly, to less than 0.5 million barrels per
day from a high of 1.6 million barrels per day in
mid-2012.
We are most concerned about Venezuela. The
50% drop in oil prices since the June 2014 highs
has increased the countrys risk of a default or
debt restructuring. Markets are pricing in a 42%
probability of default within one year, increasing to
a 90% probability in five years. While the impact
of an outright default or restructuring will not be
significant, social unrest could lead to disruptions
to oil production.

The United States is constructing Ebola treatment units in West Africa.

32

Goldman Sachs january 2015

Ebola Epidemic

Finally, while an Ebola epidemic


spreading beyond Liberia, Sierra Leone
and Guinea is still a low-probability
risk, West Africa is far from free of
Ebola virus transmission. The late
December 2014 lab incident at the
Centers for Disease Control and
Prevention, as well as a new confirmed
case involving a health-care worker
returned to Scotland from West Africa, serve as
stark reminders of the continued risks of Ebola.

Key Takeaways
In our 2009 Outlook, Uncertain But Not
Uncharted, we underscored the uncertainty
surrounding our economic and investment
outlook by stating that it was with a strong
dose of humility that we put forth our Outlook
for 2009. Today, we put forth our views with an
equal amount of caution. American economist
John Kenneth Galbraith said one of the greatest
pieces of economic wisdom is to know what you
do not know.31 This sentiment is worth repeating
today. There are many factors that will affect our
clients portfolios that are not knowable in this
environment.
Critically, we worry that in spite of all their
insights and expertise, monetary policymakers
in the United States, the
Eurozone, Japan and
China are unlikely to get
it right every time. The
Federal Reserve may be
too slow or too fast to
tighten, the ECB may be
embarking on quantitative
easing too little and too
late, the BOJ may be the
only arrow left in Prime
Minister Abes quiver and
China has to walk the
fine line between creating
enough stimulus to avert a
big slowdown but not so
much that it worsens an
already heavily indebted
credit profile.

Our view of US preeminence has served


our clients well for six years. We maintain our
recommendation that clients stay fully invested
in US equities with some tactical overweight
allocations to high-yield bonds and to the US
dollar relative to the euro and the yen. We
recommend that clients tactically overweight
certain EAFE equities as well, given very favorable
valuations. And, in line with our views last year,
we recommend that clients carefully reassess
their strategic allocation to emerging markets as
we believe these countries will face considerable
economic and political headwinds.

Outlook

Investment Strategy Group

33

SECTION II

2015 Global
Economic Outlook:
Global Divergences

although the worlds economies rarely travel exactly the

same avenues, their routes seem particularly divergent today.


Consider that growth in the US and UK is projected to be
above trend while that of emerging markets is below trend
and slowing. Even within the developed markets, the expected
pickup in the US stands in contrast to the ongoing economic
malaiseand persistent deflationary concernsplaguing Japan
and the Eurozone.
Last years 46% decline in oil prices adds another dimension
to these dissimilarities, both across countries and within
them. Naturally, declining fuel costs are positive for many net
oil importers, such as the US, and negative for commodity
exporters, many of them emerging countries. Yet even within
the beneficiary countries, the resulting declines in energy-related
employment and capital investments can generate notable
offsets. Moreover, the lower headline inflation that accompanies
lower oil prices complicates the fight against low inflation for
some central banks, such as the ECB.

34

Goldman Sachs january 2015

Outlook

Investment Strategy Group

35

While we expect uneven global growth


this year, it is still positive and better
than last year.

United States: From Recovery


to Above-Trend Growth

For those expecting the US economy


to reach escape velocity in 2014,
actual GDP growth was admittedly
disappointing. After all, contracting
GDP in the first quarter will likely leave the
full-year number similar to the subdued 2.3%
annualized pace of the post-crisis era. Even worse,
it comes five years into the recovery, bolstering
the notion that the US remains trapped in secular
stagnation.
Yet last years headline GDP figure belies a
notable improvement in underlying US economic
momentum. Exhibit42 shows that payroll gains
have improved in each of the last four years and
now stand at levels consistent with previous, more
robust economic expansions. At the same time,
initial jobless claims, included in the Conference
Boards suite of leading economic indicators, are
plumbing 14-year lows and sit 17% below year-ago
levels. Alternative real-time measures of economic
activity, such as Goldman Sachs Current Activity
Indicator (CAI),33 also highlight the improving pace
of US growth, as does rising business confidence.
Indeed, Chief Executive magazines CEO Confidence
Index, which has an 86% correlation with real
GDP growth, recently rose to a new cycle high.34 In
short, last years headline GDP is a poor proxy for
underlying US growth today.
Against this backdrop, we believe the US
economy is transitioning from a substandard
recovery to an above-trend expansion. There
are two parts to this story. First, each of the

This multi-speed growth and inflation backdrop


necessitates equally divergent monetary policies.
Whereas the Federal Reserve and the Bank of
England (BOE) have already ended their quantitative
easing programs, the ECB is on the verge of beginning
large-scale bond purchases. Even more notably,
the BOJs asset purchases are expected to vastly
exceed those of any of its peers, driving its balance
sheet to 91% of Japanese GDP by the end of 2016.
Remarkably, these differences are set to become
starker, as the rate hikes we expect from the Federal
Reserve and the BOE in 2015 will almost certainly
not be emulated by either the ECB or the BOJ.
Nevertheless, these very different paths may
still share a common destination. While we expect
uneven global growth this year, it is still positive and
better than last year. In fact, analysts have estimated
that 2014s oil decline could boost world real GDP
growth by more than one percentage point this
year.32 Moreover, the differences in monetary policy
discussed belie a world still awash in global liquidity,
as the asset purchases of the BOJ and the ECB are a
sizable offset to policy tightening elsewhere.
In short, we expect better growth and some
tightening in the US and UK. Even so, our forecast
does not call for a rapid normalization in interest
rates given the impact of lower oil and excess
global slack on inflation (see Exhibit41).

Exhibit41: ISG Outlook for Developed Economies


United States

Eurozone

United Kingdom

Japan

2014

2015 Forecast

2014

2015 Forecast

2014

2015 Forecast

2014

2015 Forecast

Real GDP Growth*

YoY

2.40%

3.00 3.75%

0.80%

0.25 1.00%

2.60%

2.00 2.75%

0.10%

0.50 1.25%

Policy Rate**

End of Year

0.25%

0.75 1.00%

0.05%

0.05%

0.50%

0.50 1.00%

0.10%

0.10%

10-Year Bond Yield***

End of Year

2.17%

2.25 3.00%

0.54%

0.50 1.00%

1.76%

2.00 2.75%

0.33%

0.25 0.75%

Headline Inflation****

Average

1.30%

0.75 1.50%

0.30%

0.00 0.75%

1.00%

0.75 1.50%

2.40%

Core Inflation****

Average

1.70%

1.25 2.00%

0.70%

0.50 1.25%

1.20%

1.25 2.00%

2.70%

1.00 1.75%

Data as of December 31, 2014.


Note: The above forecasts have been generated by ISG for informational purposes as of the date of this publication. They are based on ISGs proprietary macroeconomic framework and there can be no assurance
that the forecasts will be achieved.
Source: Investment Strategy Group, Datastream.
* 2014 real GDP is based on GS Global Investment Research estimates of year-over-year growth for the full year (except for the UK, where the estimate is from ISG).
** For Japan policy rate, we show the unsecured overnight call rate.
*** For Eurozone bond yield, we show the 10-year German Bund yield.
**** For 2014 CPI readings, we show the latest year-over-year CPI inflation rate (November). Japan core inflation excludes fresh food, but includes energy.

36

Goldman Sachs january 2015

Exhibit42: Average Monthly Payroll Gains

Exhibit44: Job Openings-to-Employees Ratio

US payroll gains have improved in each of the last four years.

Job openings have recouped their pre-crisis highs.

Average Monthly Change


in Nonfarm Payrolls
(thousands)

Job Openings Rate


4.0%

300
241

250
200

174

186

194

3.3
3.0%

150
100

3.5%

2.5%
88
2.0%

50
0

1.5%
2010

2011

2012

2013

2014*

2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

Data through November 2014.


Source: Investment Strategy Group, Datastream.
* Average for 2014 is through November.

Data through October 2014.


Note: Job openings rate is defined as job openings divided by the sum of number of employees plus
job openings for a given period.
Source: Investment Strategy Group, Federal Reserve Bank of St. Louis.

Exhibit43: Fiscal Policy Impact on GDP Growth

should underpin stronger consumer spending, an


ongoing housing recovery and continued business
investment.

The drag from fiscal cutbacks and tax increases has largely
run its course.
Percentage Points
0.5

Estimated Fiscal Policy Impact on Real GDP Growth*


Average 201114

0.3

0.0
-0.1
Forecast
-0.5
-0.8
-0.9

-1.0
-1.1
-1.5
-1.7
-2.0
2011

2012

2013

2014

2015

Data as of December 29, 2014.


Note: Impact on real GDP growth relative to a baseline forecast excluding the effects of fiscal consolidation.
Source: Investment Strategy Group, Macroeconomic Advisers, Goldman Sachs Global Investment Research.
* Estimates and forecasts by Goldman Sachs Global Investment Research.

major growth headwinds that have plagued the


US in recent yearsfiscal retrenchment, high
unemployment and consumer/financial sector
deleveragingis abating. Second, we reach this
inflection point just as the engine of US growth,
the consumer, is set to receive a notable boost
from falling energy prices. Together, these factors

Outlook

Investment Strategy Group

Waning Headwinds

There has been no shortage of headwinds for the


US economy in the last six years, a typical state
of affairs in the aftermath of a financial crisis. But
importantly, these drags are waning. The fiscal
cutbacks and tax increases that have subtracted
almost a percentage point from annual US GDP
growth since 2011 have now largely run their
course, as shown in Exhibit43. In fact, government
payroll growth turned positive in 2014 after five
consecutive years of decline.
At the same time, employment is normalizing.
The December 2014 release of the Bureau of Labor
Statistics Job Openings and Labor Turnover Survey
(JOLTS) reported 4.8 million open jobs, exceeding
the 2007 peak. Even adjusting for employment
growth over that time leaves the job openings rate
at pre-crisis highs (see Exhibit44). In turn, we
expect average nonfarm payroll gains of more than
200,000 per month to continue, ultimately pushing
the headline unemployment rate to 5.5% by the
end of 2015.
The economy should also benefit from cleaner
balance sheets as we enter 2015. Exhibit45 shows
that both the consumer and the financial sector, the

37

Exhibit45: Household and Financial Sector


Leverage

Exhibit47: US Homeownership Rate

The bubble in homeownership has been completely reversed.

The private sector has reduced leverage dramatically.


Financial
Obligations Ratio
(% of Disposable Income)

Financial Sector
Leverage Ratio
(Assets/Equity)

20
Household Financial Obligations Ratio
Average Since 1980
Financial Sector Leverage Ratio (right)
Average Since 1989

19

10.0

17

16.5

69

12

68

10

US Homeownership Rate
Average 196598

67
66
65

16

15

14

7
1980

70

13

11

18

Percentage Points

1985

1990

1995

2000

2005

64.4
64
63
62
1965

2010

1970

1975

1980

1985

1990

1995

2000

2005

2010

Data through Q3 2014.


Source: Investment Strategy Group, Datastream.

Data through Q3 2014.


Source: Investment Strategy Group, US Census, Datastream.

Exhibit46: Bank Loan vs. GDP Growth

moderating, which should enable consumers to


increase their spending in line with further income
gains. Second, lending standards should remain
accommodative, given banks capital ratiosthe
highest in decadesand the improving credit
profile of their borrowing base. Notably, bank loan
and lease growth is now exceeding GDP growth,
providing a positive credit impulse to the economy
(see Exhibit46).
The housing market, another area that has
weighed on the US recovery, also stands to benefit.
Exhibit47 makes clear that falling homeownership
is less likely to be a drag going forward, given
the complete reversal of the housing bubble runup. Moreover, improving labor markets should
increase housing demand, as should recent efforts
by the Federal Housing Finance Agency to expand
credit to a wider range of borrowers. On this
point, any incremental housing demand should
disproportionately benefit new home construction,
as the paucity of new construction in recent years
has left the market with few excess housing units
to absorb. Given how far household formation sits
below its long-term average, this is a potentially
powerful tailwind for US housing starts (see
Exhibit48). In short, todays subdued level of
residential investment provides ample scope for
further upside (see Exhibit49).

Bank loans are growing faster than GDP, supporting a healthy


economy.
Bank Loan and Lease Growth
Less GDP Growth (%)
15
10
5
1.7

0
-5
-10
-15
1974

1979

1984

1989

1994

1999

2004

2009

2014

Data through Q3 2014.


Source: Investment Strategy Group, Federal Reserve Bank of St. Louis.

two most overleveraged areas of the economy prior


to the financial crisis, have already expunged the
excesses of the previous cycle. Indeed, the financial
obligation ratio of US households has fallen from
around 18% in 2007 to just 15.3% today, a level
last seen in the early 1980s.
Healthier private sector balance sheets have two
positive implications for our economic forecast.
First, the persistent drag from debt repayment is

38

Goldman Sachs january 2015

Exhibit48: Housing Demand vs. Supply

Exhibit49: Residential Investment in the US

Household formation has room to rise and boost housing starts.

Residential investment has ample scope for further upside.

Thousands

% GDP

1400

Supply

Demand
1160

1200

8
7
6

1000
800

715

600

511

4.7

4
3.2

400

200

Residential Investment Share of GDP


19502013 Average

1
0
2-Year Average Household
Formation

Average 1984-2014
Household Formation

2-Year Average of Housing


Completions Minus Scrappage

Data through Q3 2014.


Source: Investment Strategy Group, Haver.

0
1985

1990

1995

2000

2005

2010

Data through Q3 2014.


Source: Investment Strategy Group, Datastream.

Energy Windfall

With consumption representing around 70% of US


GDP, the more than 40% oil price decline last year
is a windfall to US consumers and hence growth.
Keep in mind that gasoline prices represent about
5% of total consumer spending and have now
declined more than 20% compared to last years
average. A decline of this magnitude is extremely
rare outside of recessions, having occurred in only
one other year since 1990. In turn, our research
colleagues equate this drop to a $125150 billion
tax cut for US consumers.35 Additionally, falling oil
prices suppress the inflation risk premium, keeping
bond yields lower than they otherwise would
be. In turn, reduced borrowing costs for both
homebuyers and businesses provide a further boost
to the economy.
Of course, not all the macroeconomic
implications are positive. Lower energy prices
are likely to weigh on energy-related capital
expenditures, as well as lower real net exports.
Already, recent announcements by several energy
exploration and production companies indicate
1520% cuts in capital expenditures this year.
Moreover, employment gains in areas with
concentrated shale activity, such as Texas, are
likely to slow.
Yet despite these crosscurrents, the net impact
of declining oil is positive for the US economy for
several reasons. First, energy-related employment
accounts for less than 1% of total US employment

Outlook

Investment Strategy Group

Exhibit50: Composition of US Employment Growth

Texas and other shale oil states account for a modest share
of US employment growth.
Average YoY Change
in Nonfarm Payrolls (mm)
4
2
0
-2
-4

Texas
Other Shale Oil States*

-6

Rest of US

-8
2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Data through November 2014.
Note: Annual average of monthly YoY changes in nonfarm payroll employment, seasonally adjusted.
Source: Investment Strategy Group, Bureau of Labor Statistics, Goldman Sachs Global Investment
Research.
* Other shale oil states are Colorado, Montana, North Dakota, Oklahoma, Utah and Wyoming.

and a disproportionate but still modest slice of


overall employment growth (see Exhibit50).
Notably, the contributions of Texas and all shale
oil states in recent years are not all that different
from their pre-crisis levels. Second, oil and gas
capital expenditures in US GDP represent about
9% of total capital spending. Importantly,
declines in energy capital expenditures and related

39

Exhibit51: US GDP Sensitivity to Falling Oil Prices

Exhibit52: Fiscal Drag on Eurozone GDP Growth

The net impact of falling oil prices is positive for the US


economy.

The drag from fiscal austerity in the Eurozone is waning.

Contribution to YoY GDP Growth


(Percentage Points)

Percentage Points

Net Exports
Investment (incl. inventories)
Consumption
Total

0.7

0.00
-0.10

0.4

-0.17

-0.25

0.1
-0.50
-0.2

-0.75

-0.5
Q4
2014

Q1
2015

Q2
2015

Q3
2015

Q4
2015

Q1
2016

Q2
2016

Q3
2016

-0.70

-0.70

2012

2013

2014

2015

Estimates

Note: Estimates based on Federal Reserve FRB/US model by Goldman Sachs Global Investment Research.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Federal Reserve.

Note: Estimates by Goldman Sachs Global Investment Research as of November 6, 2014.


Source: Investment Strategy Group, Goldman Sachs Global Investment Research.

employment are generally offset by gains in the


larger, nonenergy areas of the economy that benefit
from lower oil prices.
This intuition is corroborated by econometric
modeling. As shown in Exhibit51, falling net
exports are more than compensated for by stronger
investment and consumption, with the benefit
peaking in the third quarter of this year. All told,
Goldman Sachs Global Investment Research
estimates that US GDP growth should be fourtenths to five-tenths higher this year as the result
of falling oil prices.36 Of course, an improving US
economy is also strengthening the dollar, which
these same models suggest could offset the energy
benefit over time. Yet for the year ahead, the
benefits from oil trump any drag from net exports.

Of course, these improvements have not gone


unnoticed by the Federal Reserve, which is likely to
raise the federal funds rate in mid-2015the first
increase in nine years. We will more fully explore
the implications of this policy shift, as well as our
broader interest rate outlook, in Section III.

Our View on US Growth

With many of the headwinds that hobbled US


growth in recent years abating, we had already
expected 2015 to see above-trend GDP growth of
around 3.4%. An unexpected collapse in oil prices
late last year only bolsters our confidence. To be
sure, the arrival of this above-trend expansion
five years into the recovery is a testament to the
numerous obstacles the US economy faced along
the way. Yet it is also a poignant reminder that the
types of cyclical excesses or inflationary pressures
that historically precede US recessions likely remain
distant risks.

40

Goldman Sachs january 2015

Eurozone: Cyclical Tailwinds,


Political Headwinds
This years economic landscape in the Eurozone
is best described as a tug-of-war between two
opposing forces. On the one hand, there are
many reasons to expect a cyclical rebound in
Eurozone growth, not the least of which is the
likely introduction of large-scale quantitative
easing by the ECB. On the other hand, slowing
reform momentum and rising political uncertainty
represent stiff headwinds to confidence,
undermining both investment and consumption.
Taken together, these offsetting dynamics set the
stage for another year of sluggish and uneven
Eurozone growth.
To be sure, several factors suggest Eurozone
growth should improve in 2015. As in the US,
the drag from fiscal austerity is waning (see
Exhibit52). At the same time, the dramatic decline
in oil prices and recent 5% decline in the tradeweighted euro are forecast to boost growth on the

Exhibit53: Eurozone Inflation

Exhibit54: Polling Results for Spains Political Parties

Declining inflation has fanned deflationary fears.

Populism is on the rise in Spain, seen in the stunning ascent


of the Podemos party.

% YoY

% of Polled
35

5
Headline CPI
Core CPI

30
26%
24%
23%

25

3
ECB
Target

2
1

0.7
0.4

20
15
10
5

-1
2004

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

Data through November 2014.


Source: Investment Strategy Group, Datastream.

order of 3040 basis points.37 Moreover, several


leading economic indicators, such as the German
Ifo Business Climate Index, have strengthened since
October, suggesting the Eurozone enters the year
on more stable footing.
Perhaps more importantly, the ECB appears
to be taking the risk of deflation seriously, even
while acknowledging that oil accounts for the
bulk of the recent decline in headline inflation (see
Exhibit53). Indeed, the ECBs policy steps last
year included lowering its policy rate to 0.05%,
providing cheap long-term loans to banks through
its Targeted Long-Term Refinancing Operations
(TLTRO) program, supporting credit creation
through asset-backed securities purchases and
using forward guidance to anchor the markets
policy expectations, thereby weakening the euro
further. Already, these and other steps are having

0
Jan-14

Popular Party
Socialist Party (PSOE)
Podemos

Mar-14

May-14

Jul-14

Sep-14

Nov-14

Data as of December 31, 2014.


Note: For each date, the charts plot the average of the four most recent polls.
Source: Investment Strategy Group, public polling sources.

Exhibit55: Europes 2015 Electoral Calendar

A slew of upcoming elections raises the risk of political


tension and stifles reform momentum.
January
May
October
Fall

Greece Parliamentary Election


UK Parliamentary Election
Portugal Parliamentary Election
Spain Parliamentary and Senate Elections

Source: Investment Strategy Group.

some impact on credit conditions. For example,


rates on bank loans to Italian and Spanish
companies, relative to German and French peers,
fell by about 60 basis points last year, and both
countries have indicated better access to credit
than a year earlier. We expect these measures to
be augmented by even bolder steps this
year, primarily in the form of corporate
and sovereign bond purchases.
To be sure, the arrival of this
That said, quantitative easing is
not without drawbacks. Not only are
above-trend expansion five years
sovereign bond purchases politically
into the recovery is a testament
sensitive, but they also undermine
member states incentives to deliver on
to the numerous obstacles the US
fiscal targets and structural reforms.
economy faced along the way.
Even worse, this threat of moral
hazard arrives at a time when reform

Outlook

Investment Strategy Group

41

Exhibit56: Popularity of French Presidents

President Hollandes popularity is the lowest on record for a


French president.
% Polled Who
Have Confidence

Hollande (2012)
Sarkozy (2007)
Chirac (1995)
Mitterrand (1981)

80
70
60
50

46
41

40

34

30
20

15

10
0
1

11

13

15

17

19

21

23

25

27

29

31

Months as President
Source: Investment Strategy Group, TNS Sofres.

momentum is already weakening. Combined, these


developments pose risks to political cohesion and
market confidence.
On this last point, we see three reasons why
political tensions are likely to escalate this year,
each to the detriment of further structural reforms
and Eurozone growth. First, populism is on the
rise across Europe, with populist parties such as
Syriza in Greece, the National Front in France and
UKIP in the UK enjoying a strong showing in the
spring 2014 European Parliament elections. The
remarkable rise of the newly formed Podemos
party in Spain provides another example (see
Exhibit54). Second, several countries, including
Spain, Portugal and now Greece, face elections
in 2015, making further reforms unlikely in the

interim (see Exhibit55). Nor can a disruptive


populist election outcome be ruled out. Third,
the risks of a political crisis are rising in France.
Notably, President Hollandes failure to reform
the French economy has led to a collapse in
his popularity to the lowest level on record for
a French president (see Exhibit56). With the
president so unpopular, it will be difficult for
France to undertake much-needed reforms, which
likely sets the stage for further tensions with
the European Commission over 2016 budgets
(see Section I for a more detailed discussion of
Eurozone risks).
In short, we expect these tensions to result
in another year of lethargic growth of between
0.251.0%. This low growth, coupled with lower
oil prices, will keep deflationary fears in focus
and make the Eurozone more susceptible to
shocks, as the ongoing Russia-Ukraine conflict
has demonstrated. As a result, the ECB is likely
to further relax policy, which should remain
supportive of Eurozone equities as well as a
weaker euro.

United Kingdom: Semi-Sweet Spot

The UK economy found its sweet spot last


year, with robust 2.6% GDP growth, rapidly
falling unemployment and low inflation that
provided cover for the BOE to remain highly
accommodative. But as with all sweets, there
can be too much of a good thing. As a result, we
see several reasons for a more moderate pace of
growth this year.
First, the 2.4 percentage point decline in the
national savings rate that underpinned
the recent surge in consumer spending
has likely run its course, evidenced by
We see three reasons why political
the latest stabilization in household
saving figures. Second, companies
tensions are likely to escalate
appetite for further investment is likely
this year, each to the detriment
to slow after blistering growth of
more than 7% last year, the strongest
of further structural reforms and
annual increase since 1989. Third, a
Eurozone growth.
slower pace of net trade is probable
given a stagnant Eurozonethe region
accounts for 40% of UK exportsand
past sterling appreciation. Fourth, the

42

Goldman Sachs january 2015

Exhibit57: Japanese Real Wage Growth

Exhibit58: EM Real GDP Growth

Real wages continue to fall in Japan as inflation outpaces


wages.

Emerging market growth is below trend growth and both are


moderating.

% YoY
6

ISG
Forecast

% YoY

Real Wage Growth

10

Real Wage Growth (6-month moving average)

Actual GDP

Potential GDP

0
-2

-1.9

-4

-4.2

6
5

-6

4
3

-8

-10

1
0

-12
2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014

1983

1987

1991

1995

1999

2003

2007

2011

2015

Data through November 2014.


Source: Investment Strategy Group, Datastream.

Data through 2015.


Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be
achieved.
Source: Investment Strategy Group, IMF, Datastream.

ongoing recovery and a gradual rise in inflationary


pressures should lead the BOE to tighten policy in
the second half of 2015, albeit at a more gradual
pace than historically. Finally, the drag from fiscal
policy should increase, with the Office of Budget
Responsibility forecasting a four-year contraction
in government spending.
Like those elsewhere in Europe, political
tensions in the UK are likely to increase this year.
Keep in mind that the May general election could
result in a hung Parliament, making coalition
building and policymaking more difficult. Even
worse, several election outcomes would increase
the likelihood of an EU-exit referendum in coming
yearsa prospect that could dent business
confidence now even though the actual referendum
would not be until 2017.
While we expect these developments to temper
the pace of growth, we nonetheless remain
constructive on UK prospects. Consumption
growth should continue, supported by higher
wage growth and subdued inflation. Meanwhile,
investment fundamentals remain sound, including
rising corporate profits and accommodative credit
conditions. As a result, we expect GDP growth of
2.02.75% this year.

Japan: Recovering From SelfInduced Recession

Outlook

Investment Strategy Group

Last year was supposed to have been a much


stronger one for Japans economy. After all, the
BOJ doubled the monetary base, and the yens
20%-plus depreciation should have been a boon to
exports. Yet the economy fell into an unexpected
recession following the implementation of a longscheduled consumption tax increase in April. As
a result, Japans GDP grew just slightly above 0%
last year, well below our 12% growth expectation.
The silver lining, however, is that last years
shortfall has catalyzed several policy developments
that we believe will stimulate growth this year.
First, financial conditions should ease further,
given the BOJ announcement in October 2014
of plans to increase the annual pace of monetary
base expansion from 60 trillion70 trillion to 80
trillion. In fact, we expect the BOJ to ease even
further this year as it is likely to fall short of its
2% inflation target. Second, Prime Minister Abe
announced that he would postpone the second
consumption tax increase from its scheduled
date this year to 2017. While we believe Japan
ultimately needs to raise taxes to address its chronic
budget deficits, this reprieve enables the economy
to regain its footing prior to the next increase.
Third, the recently announced 2.5 percentage point

43

Exhibit59: Chinese GDP Growth

China is modulating the growth slowdown through targeted


doses of stimulus.
Real GDP Growth

ISG 2014 Forecast

11%

%YoY
%QoQ, SAAR

10%

Bloomberg Consensus

9%
8%

unfavorable demographics remain a headwind to


the countrys long-term fiscal sustainability, given
its aging and shrinking population. While the
government has pledged to address these issues
as part of Abes Three Arrows, the effectiveness
of these policies remains uncertain. Even so, these
longer-term concerns are unlikely to derail our
modest expectations for GDP growth of 0.5
1.25% in 2015.

7%
6%
5%

Reserve requirement
rate cut, National
Development and
Reform Commission
(NDRC) accelerates
project approvals

People's Bank of China conducts


open market operations, NDRC
accelerates project approvals

"Mini Stimulus"
focused on
railways and
social housing
(MarJun '14)

Emerging Markets: Still


Emerging and Now Slowing

Growth in emerging economies disappointed


again in 2014, registering a third consecutive year
of below-trend expansion. While weak demand in
Data through Q3 2014.
key developed trading partners explains part of this
Source: Investment Strategy Group, Datastream, National Bureau of Statistics of China, Bloomberg.
shortfall, it is not the whole story. As we have noted
in other reports, structural bottleneckssuch as
poor governance and low-quality infrastructure
reduction in the corporate tax rate and 3.5 trillion are also impeding growth. In fact, not only is actual
supplementary budget should boost consumption
growth tracking below trend, but the level of trend
and help small and medium-size enterprises.
growth itself is falling (see Exhibit58). Based on
There are other reasons outside of policy to
our estimates, trend growth has slowed in about
believe that Japans GDP growth will accelerate.
two-thirds of the main emerging economies since
For one, the pickup we expect in US GDP growth
2011, eroding the once-large growth differential
should benefit Japans exporting sectors and more
they enjoyed relative to developed economies.
than offset the expected slowdown in China. In
Some combination of productivity-enhancing
addition, our forecast for further yen depreciation
structural reforms and increased global demand
this year should aid Japans exporting sectors.
is needed to arrest this slide. Yet overall progress
Finally, the economy should benefit from the
is limited everywhere except for India, Mexico
dramatic decline in oil prices given its heavy
and China (and progress in China is slower
reliance on energy imports.
than it ought to be). At the same time, the
Of course, these cyclical tailwinds do not
scope for additional support from fiscal and
obviate the need to address Japans significant
monetary policies is paltry after several years
structural challenges. Although emerging from
of uninterrupted stimulus. For this reason,
decades of deflation is ultimately constructive
growth in emerging economies is likely to remain
for Japan, it comes at the expense of real wage
subdued, although still supported by ample global
growth in the near term, as inflation has increased
liquidity and the net positive impact of lower oil
faster than wages (see Exhibit57). In addition,
prices. Based on this mixed backdrop, we expect
growth in emerging economies to be
marginally slower than last years
4.6%. Within emerging markets,
Chinas leaders appear willing to accept
the outlook is most challenging for
countries in emerging Europe and
a slower pace of reform in exchange
Latin America, given their exposure
for greater near-term stability.
to the flagging Eurozone recovery and
falling commodity prices, respectively.
4%
Q4 2010 Q2 2011 Q4 2011 Q2 2012 Q4 2012 Q2 2013 Q4 2013 Q2 2014 Q4 2014

44

Goldman Sachs january 2015

Emerging Asia

Despite slowing growth in China, economies in


emerging Asia continue to outperform their global
peers. Although we expect this to continue in 2015,
weak global demand is testing a region whose
economies are heavily reliant on exports. Even
so, countries with strong links to the US, such as
South Korea and Taiwan, should benefit from US
strength. At the same time, most countries in Asia
stand to benefit from lower oil prices, whichshould
boost consumption, increase investment and reduce
inflation. Lower inflation, in turn, should allow
fiscal and monetary policies to remain supportive,
leading us to expect a slight pickup in growth in
Asia outside China.
China: Chinas once-booming economy is slowing
amid weaker investment and sluggish export
growth. Yearly GDP growth dropped to 7.3% in the
third quarter of 2014, the slowest pace since the first
quarter of 2009, in the midst of the global financial
crisis. Worse still, higher-frequency indicators, such
as industrial production and energy consumption,
suggest that economic activity may have weakened
further in the final months of the year.
Although policymakers in Beijing agree that
the debt-fueled expansion of recent years is not
sustainable, they are acutely aware that the pace
of the slowdown must be gradual enough to avoid
pushing highly leveraged state-owned enterprises
and local governments into default, with possibly
severe consequences for Chinas banking system.
For that reason, the government has provided
targeted dollops of stimulus whenever growth
slowed more than expected, with the aim of easing
the transition, especially for small and medium-size
enterprises (see Exhibit59). More recently, Chinese
leaders reduced official interest rates as an added
stimulus measure. If growth should weaken anew,
further measures are likely.

While the government certainly has the


resources to boost short-term growth, doing
so continuously only deepens the economys
dependence on easy credit and further delays
much-needed reforms. So far, Chinas leaders
appear willing to accept a slower pace of reform in
exchange for greater near-term stability. We expect
this pattern to continue in 2015.
Based on the foregoing, we expect GDP growth
to slow further in 2015 to a range of 6.57.5%,
with inflation remaining in the low single digits.
Our forecast embeds a further deceleration in
investment, stable consumption growth and a
modest uptick in external demand. At the same
time, we expect fiscal and monetary policies
to remain supportive and be relaxed further if
growth disappoints.

India: India has been a rare bright spot among


emerging economies. After slowing for three
consecutive years, GDP growth rebounded in 2014
on the back of the landslide election of Prime
Minister Narendra Modi, who has promised to
reform the Indian economy and lay the foundations
for faster growth. His administration is intent on
tackling long-standing supply-side bottlenecks,
such as frequent electricity shortages, and
reining in Indias large fiscal deficit and unwieldy
bureaucracy. Although expectations are running
high, the economic response has thus far been
muted. After an initial sharp pickup in investment,
it appears that economic activity has eased again.
While the ultimate success of the Modi
government remains uncertain, several other
factors support our constructive view on the
Indian economy. First, India has made considerable
progress reducing its vulnerability to sudden
swings in capital flows by reducing its current
account deficit and bolstering its foreign exchange
reserves. The recent drop in oil prices should
further benefit Indias current account.
Second, improved international
investor sentiment toward India has
The outlook for Latin America is
manifested itself in stronger portfolio
investment inflows, which we expect
uneven, with an incipient recovery
to continue in 2015. Finally, the
in Mexico pitted against continued
central bank has regained credibility
by bringing down inflation from more
lackluster growth in South America.
than 10% at the end of 2013 to less

Outlook

Investment Strategy Group

45

The Russian economy seems


headed for a sharp contraction under
the intense pressure of economic
sanctions and low oil prices.

than 6% currently. This improvement, if sustained,


will give the central bank room to cut rates and
support investment going forward.
We are therefore cautiously optimistic about
the outlook for Indias economy and project GDP
growth to increase to 5.36.3% in 2015.
Latin America

The outlook for Latin America is uneven,


with an incipient recovery in Mexico pitted
against continued lackluster growth in South
America. Low commodity prices and declining
competitiveness continue to weigh on the
performance of the laggards. Despite low growth,
these economies are close to full capacity owing to
supply-side bottlenecks, leaving them with virtually
no room for fiscal or monetary stimulus. Absent
a new commodity price boom or productivityenhancing reforms, the regions underperformance
is likely to persist.
Mexico continues to stand out. Although
growth disappointed in 2014, we believe the
country is well positioned to benefit from the
ongoing recovery in the US, its main trading
partner. Structural reforms in recent years have
primed the economy to become more efficient and
competitive, while prudent fiscal and monetary
policies provide the flexibility to deal with external
shocks. Being a small net exporter of oil, Mexico
will no doubt suffer from lower oil prices, but the
impact on growth should be manageable with the
exchange rate expected to absorb a large part of
the shock.
Brazil: The Brazilian economy is facing a
challenging combination of low growth and high
inflation. Falling commodity prices are hurting
Brazils main exports while interventionist policies
have contributed to a contraction in investment

46

Goldman Sachs january 2015

and a sharply weaker currency.


However, following a narrow win
in the October 2014 presidential
election, the government has signaled
its intention to adjust course, if
only to avoid a ratings downgrade
of Brazils government debt. The
adjustment would entail tighter
monetary and fiscal policies, including
increases in regulated prices. While
this policy mix could ultimately help to rebuild
confidence and support a recovery in investment, it
will be contractionary in the near term.
Given this backdrop, we expect relatively
modest GDP growth of 0.31.3% in 2015,
supported by a slight pickup in investment from
a low base. Despite this sluggish growth, inflation
will remain elevated near the top end of the central
banks target band (2.56.5%), as the bank is
unlikely to tighten aggressively and administered
prices are set to rise.
Europe, Middle East and Africa (EMEA)

Countries in the EMEA region are caught between


disappointing growth in the Eurozone and a
Russian economy spiraling into recession, with
this year unlikely to offer a reprieve on either
front. A partial offset comes from the fact that
most countries in the region still have some room
to use fiscal or monetary policy to support growth.
This is not true for Russia, Turkey and South
Africa, however. Particularly in the latter two
countries, policy flexibility remains very limited
given their sizable twin deficits, which make
foreign capital skittish.
Russia: The Russian economy seems headed for
a sharp contraction under the intense pressure
of economic sanctions and low oil prices. The
situation came to a head last year in the third week
of December when the ruble fell dramatically,
prompting the central bank to hike policy rates
by 650 basis points, the biggest rise since the
1998 crisis. The resulting increase in the cost of
capitalin combination with ongoing sanctions
and capital flightwill severely depress investment.
At the same time, domestic consumers are likely to
face weakening labor markets and high inflation.
Already, consumer prices are rising at a rapid pace

of more than 9% year-over-year owing to reduced


supplies of goods and a sharply weaker exchange
rate. Until these pressures abate, the central bank
will maintain tight monetary policy. Fiscal policy,
on the other hand, is beholden to the low price of
oil. Although the sharp depreciation of the ruble
is substantially offsetting the immediate impact
of the lower oil price, ultimately this dynamic is
inflationary and therefore not sustainable.
Against this backdrop, we expect GDP to
contract by 35% in 2015 and inflation to remain
in the high single digits. Given the continuously
changing situation, this projection is especially
uncertain. The risks around this outlook depend
very much on the price of oil and the standoff with
Ukraine. A higher oil price and reduced tensions
in Ukraine could ease pressure on the ruble and
allow the central bank to cut rates. In contrast,
an escalation of the conflict could lead to more
sanctions and incremental pressure on growth.
Finally, the most toxic combination of low oil
prices, a depreciating currency and increasing
stresses in the banking system could result in an
even deeper slump in the Russian economy.

Outlook

Investment Strategy Group

47

SECTION III

2015 Financial Markets


Outlook: Not Yet Out to
Pasture

many expect the now six-year-old bull market in risk

assets to be put out to pasture in 2015. After all, this rally


has already outlasted the post-WWII average by a full year.
In addition, the S&P 500 is more than three times its 2009
trough level. Such strong gains in not only US equities but also
other global risk assets have left their valuations full and more
vulnerable to adverse shocks. As the old English proverb reminds
us, A full cup must be carried steadily.
While investors admittedly have a narrower margin of safety
today, we do not agree that the sun has already set on this bull
market. As we noted in last years Outlook, bull markets do not
die of old age, but more typically of severe economic imbalances,
recessions and tight monetary policy. In contrast, todays
unusual combination of ample global slack, improving economic
momentum and highly accommodative monetary policy is
historically inconsistent with the typical conditions at market tops.
Keep in mind that financial conditionsan important driver
of economic growth and therefore risk assetsremain incredibly
accommodative. Countries with zero-interest-rate policies
48

Goldman Sachs january 2015

Outlook

Investment Strategy Group

49

While investors admittedly have a


narrower margin of safety today, we do
not agree that the sun has already set
on this bull market.

represent more than 80% of the worlds market


capitalization, while 50% of the worlds
government bonds have a yield of less than 1%.38
At the same time, the projected $1.5 trillion in
balance sheet growth by the ECB and the BOJ
is likely to offset the widely telegraphed Federal
Reserve rate hikes later this year.39 Lastly, the
dramatic decline in oil that some analysts are
equating to a $1 trillion global tax cut has already
pushed oil-adjusted US financial conditions to their
easiest level of the post-crisis period.40 Against
this backdrop, corporate earnings should continue
to rise along with global growth, providing
fundamental support for higher stock prices.
While this bull run can continue, its pace
is likely to slow. Strong erstwhile returns have
borrowed from future gains, leaving us to expect
more modest returns with higher volatility across
asset classes. Even so, there are pockets of tactical
opportunity that offer investors an attractive
alternative to high-quality bonds. As we discuss
next, these include dollar longs against the euro,
yen and Australian dollar, long the Indian rupee,
hedged short exposure to gold and copper,
hedged long exposure to Japanese and US energy
stocks, Spanish equities, US banks and high-yield
corporate credit (see also Section I).

US Equities: The Maturing Bull

For even the most steadfast bulls,


the S&P 500s performance since
the trough of the financial crisis has
been striking. Price returns over
comparable rolling time periods
have been lower 99% of the time
historically, as seen in Exhibit61.
Even more remarkable, these gains
have come with volatility no worse than average.
The S&P 500 generated a 204% price return with
about 17% annualized volatility from March
2009 through December 2014, a combination
that has been bested only a tenth of the time in the
last seven decades. Needless to say, risk-adjusted
returns in US equities have been quite attractive
over the last six years.
Although this bull market will eventually end,
the question facing investors today is whether its
apex will occur in 2015 or worse yet, has already
happened. Our own view is that this running
of the bulls will continue, albeit at a pace more
akin to walking. Put simply, the levers of equity
returnsvaluations, margins and sales growth
are still working but theyre becoming more
difficult to pull. As we mentioned in Section I of the
Outlook, US equity valuations are already elevated,
standing in the 9th decile of their historical
distribution. While higher valuations are certainly
possible, they are not the most likely outcome in a
year when the Federal Reserve is expected to raise
interest rates after six years at the zero bound.
Looking back at 32 rate-hike cycles initiated in
developed markets since the mid-1980s, the median
trailing price-to-earnings multiple declined 7% in
the six months following the first rate increase.41

Exhibit60: ISG Global Equity Forecasts: Year-End 2015


End 2015 Central
Case Target Range

2014 YE

Implied Upside From


Current Levels

Current Dividend Yield

Implied Total Return

S&P 500 (US)

2,059

2,075 2,150

1 4%

2.0%

Euro Stoxx 50 (Eurozone)

3,146

3,300 3,500

5 11%

3.7%

9 15%

FTSE 100 (UK)

6,566

6,950 7,150

6 9%

4.7%

10 14%

TOPIX (Japan)

1,408

1,550 1,650

10 17%

1.7%

12 19%

956

930 1,020

-3 7%

2.8%

0 9%

MSCI EM (Emerging Markets)

Data as of December 31, 2014.


Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
Source: Investment Strategy Group, Datastream, Bloomberg.

50

Goldman Sachs january 2015

3 6%

Exhibit61: S&P 500 Returns Since the Financial


Crisis Trough

Exhibit62: Foreign Profits Sensitivity to Rising


US Dollar

Historically, price returns have been lower in 99% of


comparable rolling time periods.

A stronger dollar typically weighs on foreign receipts.

Rolling Price Returns, Period


Defined by Post-Crisis Trough

YoY Change in Annual Average


Receipts from Rest of World

300%

60%

250%

50%

200%

40%

150%

30%
20%

100%

10%

50%

0%

0%

-10%
-50%

-20%
-20%

-100%
33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 13

-15%

-10%

-5%

0%

5%

10%

15%

YoY Change in USD Effective Exchange Rate (Annual Average)

Data as of December 31, 2014.


Note: Rolling return period is defined as equivalent to that from the S&P 500s March 9, 2009 trough,
to today. Past performance is not indicative of future results.
Source: Investment Strategy Group, Bloomberg.

Data through year-end 2013.


Source: Investment Strategy Group, U.S. Bureau of Economic Analysis, Bank for International
Settlements.

Assuming the Federal Reserve hikes interest rates


at the midpoint of 2015, valuation multiples could
struggle into year-end.
The remaining two levers are equally
constrained. Profit margins already stand near
all-time highs and further gains will be challenging
this year as wagesthe bulk of most firms costs
increase along with an improving labor market.
As a result, rising profit margins likely cant be
counted on to offset falling valuations, as they have
in historical hiking cycles. The same can be said of
sales growth, which is usually accelerating strongly
at the point when central banks begin raising rates,
providing an offsetting boost to earnings. Yet

today, the 40% of S&P 500 profits derived from


foreign sources is exposed to soggy global growth
and a strengthening dollar, which has historically
weighed on such sales (see Exhibit62).
In short, todays high multiples and margins
imply lower prospective returns, with the sizable
market advance since the trough having borrowed
gains from future years. This need not imply an end
to the bull market, but it does suggest investors
risk-adjusted performance is unlikely to duplicate
the recent past. Our central case for 2015 reflects
this, calling for positive but below historical
average total returns of between 36% (see
Exhibit60 and Exhibit63).42

Exhibit63: ISG S&P 500 Forecast: Year-End 2015


2015 Year-End

Good Case (20%)

End 2015 S&P 500 Earnings


Op. Earnings $130

Rep. Earnings $124
Trend Rep. Earnings $102

S&P 500 Price-to-Trend Reported Earnings

End 2015 S&P 500 Fundamental Valuation Range

End 2015 S&P 500 Price Target (based on a combination


of trend and forward earnings estimate)

21 23x

Central Case (60%)



Op. Earnings $121126

Rep. Earnings $112117
Trend Rep. Earnings $102

18 21x

2,140 2,350

1,840 2,150

2,300

2,075 2,150

Bad Case (20%)



Op. Earnings $99

Rep. Earnings $80
Trend Rep. Earnings $102

16 17x
1,630 1,750
1,750

Data as of December 2014.


Note: Forecast for informational purposes only. There can be no assurance that the forecasts will be achieved. Please see additional disclosures at the end of this presentation.
Source: Investment Strategy Group.

Outlook

Investment Strategy Group

51

Exhibit64: Probability of Higher S&P Returns

Exhibit66: Valuations at End of Previous Bull Markets

High starting valuations often moved even higher in past


episodes, generating strong returns.

Prior bull cycles have ended with multiples higher than


todays levels.

Probability

Trailing Price-to-Earnings Ratio

25%

35
31

30
20%

25

18

18

18

Feb-1966

Jun-1948

10

Nov-1980

10%

16

14

15

Nov-1968

15%

22
Current

Oct-2007

20

22

22

19
18

5%

Mar-2000

Aug-1987

Dec-1961

May-1946

40%

Jan-1973

30%
One Year Price Return of at Least

Jul-1990

20%

Aug-1956

0
0%

Data as of December 31, 2014.


Note: Based on historical S&P 500 returns beginning in September 1945.
Source: Source: Investment Strategy Group, Bloomberg, Robert Shiller.

Data as of December 2014.


Source: Source: Investment Strategy Group, Bloomberg, Robert Shiller.

Exhibit65: Historical Bull Market Analogs

Exhibit67: Characteristics of Market Peaks

The rally has upside in both time and price to match historical
bull markets.

Todays economic backdrop is not consistent with previous


market peaks.

Bull Market Beginning


Jun 1949
Oct 1974
Aug 1982
Oct 1990

Years Remaining
1.3
0.4

3.7

Remaining Return*
71%

18%
87%

Data as of December 31, 2014.


Note: Time and price return remaining if the current bull market matched the historical episodes in table.
Source: Investment Strategy Group, Bloomberg.
* Remaining return refers to the return from the end of the current bull market to the end of the
other bull markets.

7%

Median (Post '48)


5.8%

6%
5%

Current/Last

5.8%

4.7%
3.8%

4%
3%
2.2%
2%

1.3%
1%

Some might ask whether it is worth taking equity


risk for such modest expected returns. Several factors
argue that it is. First, while low returns may be our
base case, equity markets frequently surprise to the
upside. That was certainly the case last year. More
broadly, periods in the post-WWII era that started
with valuations similar to todays experienced
better than 10% annualized returns over the next
five years about a quarter of the time. Indeed, high
starting valuations often moved even higher in past
episodes, generating strong subsequent returns (see
Exhibit64). Second, while flat or even down years
are common during the course of most bull markets,
they do not necessarily portend an end to them. The
S&P 500s 66% gain since a modest price decline in

52

Goldman Sachs january 2015

0%
Unemployment Rate

Yield of 10-Year Treasury

Inflation (YoY)

Data as of December 31, 2014.


Source: Investment Strategy Group, Shiller, Bloomberg, Datastream.

2011 is a poignant reminder of why selling on that


basis alone is ill-advised. Third, the current advance
has room in both time and price to match other
historical bull markets, as seen in Exhibit65. It is
notable that about half of these episodes peaked at
a price-to-trailing earnings ratio above todays levels
(see Exhibit66). Finally, even with the headwinds
mentioned above, forward equity returns are still

Exhibit68: Normalized Likelihood of an Equity Bust

Exhibit70: Price-to-Trend Earnings

The odds of an equity plunge remain well below levels of


prior market tops.

Todays macroeconomic backdrop supports currently


elevated multiples.

Z-score of the estimate of the


probability of an equity bust

40

35

Price-to-Trend Earnings
Model Based on Macroeconomic Inputs

30

25

20
0
15
-1

10

All
With Recession

-2

With Deep Recession

-3
85

87

89

91

93

95

97

99

01

03

05

07

09

11

13

50

55

60

65

70

75

80

85

90

95

00

05

10

15

Data as of Q2 2014.
Note: Risk of equity bust (-20% drop) is calculated as an average for the following 5-9 quarters.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research.

Data as of December 31, 2014.


Source: Investment Strategy Group, Robert Shiller.

Exhibit69: Time to Recession Impacts Length of


Bull Markets

markets. Indeed, todays unemployment rate,


low bond yields and low inflation stand in sharp
contrast to historical stock market peaks, as
seen in Exhibit67. Furthermore, the risk of an
equity bust arising from fundamental economic
imbalances stands well below the levels seen at
major market tops in 1987, 2000 and 2007 (see
Exhibit68).43 With few signs of a recession on the
horizon, the current business cycle, and this bull
market, likely have room to run (see Exhibit69).
Of course, there certainly are risks, and many
are warning that todays elevated profit margins
and valuations are inflating an unsustainable
bubble. While we acknowledge a narrower margin
of safety at present, there are several arguments
in favor of a less alarmist view. Todays valuations
are broadly justified on the basis of the current
macroeconomic backdrop, particularly given the
low inflation and very modest inflation volatility
we are experiencing (see Exhibit70). While the
late 1990s represented another period of higher
valuations supported by non inflationary growth,
note that valuation multiples significantly exceeded
their fundamental value during that time.
There are also structural underpinnings to
current margins that make them more durable
than is widely appreciated. Keep in mind that
the technology sector, which operates at much
higher margins than the market as a whole, has

With a recession unlikely, the bull market has room to extend.


Length of Bull Market (Years)
10
9
R = 44%

8
7
6
5
4
3
2
1
0
0

10

Time to Next Recession (Years)


Data as of December 2014.
Note: Based on data since WWII.
Source: Investment Strategy Group, Bloomberg, National Bureau of Economic Research.

likely to be positive and exceed those of cash or


bonds over the next five years (see Section I of the
Outlook). For all these reasons, we accord a 20%
probability to our good-case scenario of the S&P
500 reaching 2,300 by year-end.
It is also worth noting that there is scant
evidence of the types of cyclical excesses or
inflationary pressures that historically end bull

Outlook

Investment Strategy Group

12

53

Exhibit71: US Labors Share of National Income

A declining labor share of income supports structurally higher


margins.
US Labor's Share of National Income
68%
66%
64%
62%
61%

60%
58%
56%
54%

29 33 37 41 45 49 53 57 61 65 69 73 77 81 85 89 93 97 01 05 09 13
Data as of December 31, 2013.
Source: Investment Strategy Group, Bureau of Economic Analysis.

Exhibit72: Hourly Compensation Costs in


Manufacturing

Cheaper labor costs in emerging markets support US profit


margins.
US$/hour
60
46
40 40 38
37 37
35 34

40
30

EAFE Equities: Stay the Course


31
27

24

20

21 19
11

10

China*

50

Philippines

52
50

Poland

Mexico

Brazil

Taiwan

Greece

Singapore

South Korea

UK

Spain

Italy

Japan

US*

Canada

Ireland

France

Netherlands

Germany

Belgium

Sweden

Data through 2012.


Note: Includes social insurance, directly-paid benefits and pay for time worked. Data for China is
estimated for combined urban units and TVEs.
Source: Investment Strategy Group, Bureau of Labor Statistics, Empirical Research Partners.
* Data for US and China is estimated for 2014.

grown from representing 8.5% of the S&P 500


index in the early 1990s to almost 20% today.
Over the same time, labor costs as a share of US
corporate revenues have slipped due to a number
of factors, including declining union membership,
the substitution of robotics for US manufacturing

54

workers and, perhaps most importantly, the


introduction of a massive pool of inexpensive
Chinese labor into the global workforce.
The resulting profit margin gains have persisted
because there is still a labor cost differential
between the US and emerging markets (see
Exhibit72). Moreover, these emerging countries
are not passing along their rising costs, preferring
to concentrate on market share at the expense of
their return on equity. For example, manufacturing
wages in China have increased more than 350%
since the country was admitted to the World Trade
Organization in 2001, yet the prices of its exports
to the US have barely budged (see Exhibit73).44
As long as the emerging markets remain more of
a supplier than a competitor to the US, the latters
higher profit margins are likely to persist.
Based on the foregoing, the US bull market has
likely entered a more mature stage characterized
by lower expected returns and potentially higher
volatility. Even so, a longer-than-normal US
business cycle should support equity returns that
are likely to exceed those of cash and bonds. In our
view, the rewards of remaining invested are still
worth the expected volatility. After all, markets are
said to climb a wall of worry, and as this discussion
highlights, there is no shortage of concerns.

Goldman Sachs january 2015

There is little question that EAFE (Europe,


Australasia, Far East) equities are attractively
valued. As shown in Exhibit74, our composite
valuation measure currently stands in the fourth
decile, meaning it has been higher about 60% of the
time. Crucially, valuations comparable to todays
levels have historically generated positive returns
86% of the time over the subsequent five years,
with an average price gain of 9%. If we include
todays 3% dividend yield, that gain increases to
12%. In the current low-return environment, that is
quite a provocative potential return.
But if the last few years have taught us
anything, it is that attractive valuations are
not necessarily a catalyst for realizing that
value. Such is the case with EAFE equities (see
SectionI), which have lagged the S&P 500
significantly over the last six years despite
suffering a similar 55% drawdown in the

Exhibit73: Change in Key Chinese Economic Variables

Chinas wages have soared while prices of its exports have


barely budged.

Exhibit74: Five-Year Annualized Price Returns


Arising from Each Valuation Decile

Current EAFE valuations have generated positive future


returns historically.

Cumulative Change Since 2005


(Measured in 2014 US$)

20%

350%

15%

100%

Average Return
14%

% of Outcomes With Positive Returns (Right)

14%

14%

75%

300%

10%

9%

250%

5%

5%

200%
150%

4%

0%

100%

50%

2%
0%
-3%

Current
Decile

-5%

50%

25%
-4%

-10%

0%
Chinese Manufacturing
Wages

China Exports

financial crisis. Moreover, the bulk of that


underperformance came in recent years, at a time
when EAFE valuations were significantly more
attractive than those in the US.
While this underperformance makes the case
for abandoning EAFE equities understandable,
we think investors should stay the course. Going
forward, continued, albeit modest, economic
growth in the EAFE regions should support positive
earnings growth, while todays dividend yield
and scope for higher valuations multiples should
also bolster returns. On the last point, Exhibit75
reminds us that sovereign bond purchases, such as
those the ECB stands on the verge of undertaking,
have been a potent elixir for equities.
Although we believe EAFE equities are unlikely
to narrow their performance gap fully with the US
in 2015, their large, favorable valuation differential
provides ample scope for upside over time. As
a result, we recommend clients maintain their
strategic allocation to EAFE equities and tactically
overweight certain countries, as we discuss next.

Outlook

Investment Strategy Group

Less Expensive

Prices
Data as of November 2014.
Source: Investment Strategy Group, U.S. Bureau of Labor Statistics, CEIC Data, Empirical Research
Partners Estimates

0%
1

US Imports from China

Valuation Decile

10

More Expensive

Data as of December 2014.


Note: Each decile reflects average of five valuation measures: price to book, price to 10-year average
cash flow, price to peak cash flow, price to 10-year average earnings, and price to peak earnings based
on the MSCI EAFE price index using data since 1982.
Source: Investment Strategy Group, Datastream, MSCI.

Exhibit75: Indexed Equity Performance Following


QE Announcements

Quantitative easing has supported equity gains historically.


Announcement Date = 100
140

US Equities
UK Equities
Japan Equities

130

127
123

120

112

110
100
90
80
-90 -60 -30

30

60

90

120 150 180 210 240 270 300 330 360

Number of Days From Announcement


Data as of December 2014.
Note: QE announcements depicted in the exhibit are as follows: US 11/25/2008, 3/18/2009,
11/3/2010, 9/21/2011, 6/20/2012, 9/13/2012. UK 3/5/2009, 5/7/2009, 8/6/2009, 11/5/2009.
Japan 10/5/2010, 4/4/2013. Indexes depicted are as follows: US S&P 500, UK FTSE 100,
JapanTOPIX. Past performance is not indicative of future results.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Datastream.

55

Exhibit76: Composition of MSCI EMU Index


Total Returns

Exhibit77: Global Real GDP Growth vs. Change in


European Profit Margins

Higher valuation multiples account for the gains in Eurozone


equities since 2009.

Stronger global growth could drive margins higher.


6%

Cumulative Since 3/9/2009

Forecast

130%
Earnings Growth
100%

110%

5%

4%

4%

Multiple Expansion

2%

70%
40%
10%

3%

0%

2%

-2%

1%
0%

-4%

-20%

-22%

-50%

-6%
-8%

09

10

11

12

13

6%

14

Change in European
Margins (YoY)
Global Real GDP Growth
(YoY % - Right)

-1%
-2%
-3%

00 01 02 03 04 05 06 07 08 09 10 11 12 13 14 15 16

Data as of December 31, 2014


Note: Based on MSCI EMU Local total return, price and earnings indices. Past performance is not
indicative of future results.
Source: Investment Strategy Group, Datastream.

Data as of December 2014.


Note: Global GDP projections are based on Goldman Sachs Global Investment Research forecasts.
Source: Investment Strategy Group, Datastream, Goldman Sachs Global Investment Research.

Eurozone Equities:
In Search of Earnings Growth

Importantly, the additional euro depreciation we


expect could provide a further boost to earnings.
After all, around 44% of Eurozone companies sales
emanate from foreign sources, making them a direct
beneficiary of a weaker exchange rate. Moreover,
the relationship between euro depreciation and
earnings has strengthened as these foreign sales
have grown in recent years (see Exhibit78).
Consequently, the risks around our 5% earnings
growth assumption are skewed to the upside.
Of equal importance, a rising earnings
backdrop should support current valuation levels,
as should ECB policy. As discussed earlier, the
historical experience of other countries suggests
that quantitative easing by the ECB could push
Eurozone equity valuations well above todays
middling levels. Indeed, current Eurozone
valuations have preceded positive price returns
over the subsequent five years 95% of the time
historically, with an average price return of 11%.
In short, we expect mid-single-digit earnings
growth, coupled with moderate valuation
multiple expansion and a 3.7% dividend yield,
to underpin a 915% total return for Eurozone
equities this year. Within the Eurozone, we believe
prospects are best for Spanish equities, due to a
combination of attractive valuations and potential

Despite triple-digit price returns since the trough of


the financial crisis in 2009, Eurozone equities have
not been firing on all cylinders. Indeed, expanding
valuation multiples drove the bulk of the gains, as
earnings actually declined over this time period (see
Exhibit76). Fortunately, we think a still-expanding
economy, further euro depreciation and highly
accommodative ECB policy are set to reverse this
earnings slide and support past valuation gains in
the year ahead.
To be sure, the Eurozones economic recovery
has been anemic, which has penalized the earnings
of its companies. Put simply, there has been less
revenue to cover these firms larger fixed costs,
leading to subdued margins and declining earnings.
The flip side of this operating leverage, however,
is that it does not require a significant improvement
in topline growth to drive margins higher. This
dynamic is evident in Exhibit77, which shows
the tight correlation between global growth and
changes in Eurozone profitability on a historical
basis. In turn, our expectation for modestly better
global GDP growth this year implies earnings
growth of around 5%.

56

Goldman Sachs january 2015

Exhibit78: Changes in the Euro vs. Eurozone


Earnings

Exhibit79: Valuations across Countries

Additional euro depreciation could provide a further boost to


earnings.
%YoY

% of Time Valuation
Less Than Current

61.1%

60%

Last years negative return has pushed UK valuations to more


attractive levels.

% Change EMU EPS

100%

% Change Euro/US$
40%

Euro Appreciation

75%
62%

20%
5.1%

2.5%
-6.5%

4.2%

1.8%

0%

1.5%

50%

44%

-3.2%
-11.7%

-20%

-13.4%

-12.8%

Euro Depreciation

30%
25%

67%

34%

35%

United
Kingdom

Spain

16%

-40%
0%

-60%

-54.4%
2009

Italy

2010

2011

2012

2013

2014

Japan

France

Germany

Belgium

Data as of December 31, 2014.


Source: Investment Strategy Group, Datastream, MSCI.

Data as of December 2014.


Note: Valuation measures include an aggregate of: price to book, price to 10-year average cash flow,
price to peak cash flow, price to 10-year average earnings, and price to peak earnings using data over
each countrys full available history.
Source: Investment Strategy Group, Datastream, MSCI.

earnings growth that exceeds that of the broader


Eurozone. In contrast, France looks least attractive
in our framework, given the political headwinds
forestalling much-needed structural reforms there.

us pause. Third, while the domestic economy is


expected to slow, its absolute growth is still well
above that of the Eurozone, providing a supportive
backdrop to continued earnings growth of around
4%. Finally, prospective 1014% total returns in
UK equities are no doubt enticing to investors in
todays low-return environment, a byproduct of
the regions hefty 4.7% dividend yield, ongoing
earnings growth and potential for valuation
expansion.
Of course, there are headwinds to this story,
too. Todays valuation discount at least partially
reflects the expectations that the Bank of England
is set to hike policy rates next year. Moreover,
while valuations have become more attractive
in the energy and material sector, the risk/
reward balance has not yet tipped enough to
recommend an outright long position. Meanwhile,
other sectors trade either near or above their
historical median valuation levels, suggesting the
undervaluation signal is not broad-based. Finally,
profit margins stand above their historical average,
limiting the capacity for a significant acceleration
in earnings growth.
The upshot of the foregoing is that while it may
still be premature to overweight UK equities, the
opportunity is coming into focus.

UK Equities: Coming into Focus


For the last several years, we have expressed a
preference for Eurozone equities over those of
the UK. This stance reflected the sizable relative
outperformance of UK equities over this time,
which made their valuations less attractive.
Moreover, we questioned the fundamental
prospects of key sectors of the FTSE 100, namely
energy and materials, which make up over 22% of
its market capitalization.
While we still prefer Eurozone equities, there
are several reasons UK equities are slowly coming
into tactical focus. First, last years negative
return has pushed overall UK valuations to more
attractive levels, particularly since earnings grew
over this period. In fact, valuations have been lower
only 34% of the time historically (see Exhibit79).
Second, the valuation compression has been
concentrated in the energy and materials sectors,
creating a better risk profile in areas that had given

Outlook

Investment Strategy Group

57

Exhibit80: JapansPrice-to-Earnings Multiple

Exhibit81: TOPIX Price Level

Japans price-to-earnings multiple now stands below its


financial crisis trough.

Japanese equities tend to rise substantially following major


policy changes.

Price to
Earnings Multiple

TOPIX Price Level


2,000

25

23.5

BOJ increases QE,


GPIF announces
planned
reallocation of
portfolio

1,800

20.6
20

Koizumi
consolidates
power after
snap election

1,600
16.1
1,400

15

BOJ
announces
QE

Abe calls
for unlimited
easing

1,200

10

1,000
5

800

600
Mar-09

2012 Average

Data as of December 2014.


Source: Investment Strategy Group, Goldman Sachs Global Investment Research.

Japanese Equities:
Climbing the Wall of Worry

Dec-14

00

01

02

03

04

05

06

07

08

09

10

11

12

13

14

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

ongoing pro-equity policy steps. In October of


last year, the BOJ announced that it would buy
additional equities as part of its larger quantitative
Despite delivering a double-digit total return last
easing program. At the same time, Japans $1.1
year, Japan remains shrouded in doubt. Longtrillion Government Pension Investment Fund
standing concerns about its poor demographics,
(GPIF) announced that it would double its
shrinking labor force and high government debt
allocation to Japanese equities. More recently, the
have been joined by fresh worries about the efficacy government announced a 2.5 percentage points
of Abenomics and risks associated with the BOJs reduction in the corporate tax rate and 3.5
massive quantitative easing program. Moreover,
trillion supplementary budget that should boost
Japan is the only major developed market whose
consumption, thereby improving business for
price-to-earnings multiple has actually declined
Japanese firms.
since 2012; it now stands below its financial crisis
Notably, such significant policy developments
trough (see Exhibit80). Remarkably, this multiple
have triggered sustained equity rallies in Japan
contraction comes as Japanese earnings have
historically (see Exhibit81). For instance, the
quietly surpassed their pre-crisis peak. Clearly,
TOPIX rallied 36% during the seven months after
investors are demanding a very high risk premium
then-Prime Minister Junichiro Koizumis party
to own Japanese equities, likely a reflection of the
consolidated power in a September 2005 snap
countrys repeated history of false dawns.
election. Similarly, Japanese equities rallied 48%
While we agree that Japan must ultimately
during the four months that followed a speech
address its key structural fault lines, we see good
of Shinzo Abes (then only a candidate for prime
reasons to overweight Japanese equities over the
minister) in November 2012 calling for the BOJ
near term. Chief among them is the governments
to deliver unlimited monetary easing. Likewise,
Japanese equities returned
24% over the month and
a half following the actual
Japan is the only major developed market
announcement of quantitative
easing by the BOJ in April 2013.
whose price-to-earnings multiple has
While Japanese equities have
actually declined since 2012.
advanced 8% on the back of
the most recent announcements,

58

Goldman Sachs january 2015

Exhibit82: Potential Inflows into Japanese Equities

Domestic flows into Japanese equities could drive a move


higher in coming months.
% of Japan Total Market Cap

Japanese companies are becoming more shareholder-friendly.


Trillion

3.5%

3.2%

3.0%
2.5%

Exhibit83: Buybacks and Dividends from


Japanese Firms

7
Dividends

5.7

2.2%

4.8

4.7
4.2

2.0%

1.5%

3.5

0.6%

3.4

3.6

2.9

1.0%
0.5%

6.5

Buybacks
6

2.0

2.2

1.2

0.4%
1

0.0%
GPIF

"Follow-on" Pension
Funds

New Bank of Japan


Demand

Combined

0
2009

2010

2011

2012

2013

2014

Data as of December 2014.


Source: Investment Strategy Group, Bloomberg.

Data through Q3 2014.


Note: Full-year dividends estimated based on data for the first half of each year. 2014 buyback data is
estimated based on data for the first three quarters of 2014.
Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research.

we believe the actual implementation of these


measures could drive equities significantly higher
in coming months. Keep in mind that GPIF will
not begin reallocating its portfolio until April of
this year. In the same way, the BOJ has purchased
only $3 billion of domestic equities since October
of last year based on our estimates, just 3% of the
expected total for the GPIF and BOJ combined. As
a result, we believe the bulk of investor flows into
Japanese equities has yet to occur.
This last point is important, as we estimate
the potential increase in demand for Japanese
equities from the GPIF and BOJ purchases
is approximately $100 billion, an amount
representing 3% of Japans current equity market
capitalization (see Exhibit82). Such an infusion
would be roughly equivalent to the entire amount
of foreign inflows into Japanese equities between
November 2012 and May 2013, a period during
which the TOPIX rose nearly 80%. While we are
not expecting a move of this magnitude, there is
certainly scope for upside.
Beyond policy developments, Japans
fundamental drivers are also supportive.
Accelerating GDP growth in both Japan and
the US should benefit Japanese earnings. So too
should the further depreciation in the yen that we
expect, particularly since export-related companies
account for 38% of TOPIX market capitalization.

On this point, our colleagues in Goldman Sachs


Global Investment Research estimate that every
10 decline versus the US dollar lifts profit growth
by roughly four percentage points. Based on
their assumption that the JPY/USD exchange rate
averages 125 in 2015, the implied boost to earnings
growth would be about 8%.
Additionally, we see scope for Japanese
multiples to rise to their historical average levels.
The two forces that have warranted a higher
risk premium for Japanese shares historically
deflation and unfriendly capital return
policiesare both abating. More specifically, the
governments commitment to ending deflation
is taking root, as evidenced by recent inflation
readings. At the same time, Japanese companies
are increasingly returning capital to shareholders,
with dividends and share buybacks reaching
multiyear highs in 2014 (see Exhibit83). Taken
together, these developments should lower the
equity risk premium to the benefit of existing
shareholders.
Against this backdrop, we think the wall of
worry facing Japan is exploitable, with our forecast
implying a 1219% total return this year. This
attractive return, which exceeds our expectations
for both the FTSE 100 and Euro Stoxx 50, is a
key driver of our Japanese equities overweight
recommendation.

Outlook

Investment Strategy Group

59

Exhibit84: Dispersion in EM Valuations

Exhibit85: Fundamentals of Emerging Market


Equities

Multiples do not offer a large enough margin of safety.

Declining profitability and increasing leverage are upping the


risk of EM equities.

Composite Normalized
Valuations Since 1994
1.6
1.2

0.9

0.8
0.4

0.1

0.0
-0.4

-0.3

-0.2

-0.2

0.3

0.4

Net Profit Margin

1.1

14%

-0.8

6.0x

Financial Leverage (Right)

12%

5.5x

10%

5.0x

8%

4.5x

6%

4.0x

4%

3.5x

Mexico (4.9%)

South Africa (7.9%)

India (7.1%)

Indonesia (2.8%)

Brazil (8.9%)

Thailand (2.4%)

Korea (14.7%)

EM

Malaysia (3.6%)

Taiwan (12.6%)

China (21.8%)

-0.9
Russia (3.2%)

-1.2

6.5x
Net Profit Margin

0.5

0.0

-0.1

Financial Leverage

16%

3.0x

2%

Data as of December 31, 2014.


Note: Based on monthly data since 1994 for Price/Forward Earnings, Price/Book Value, Price/Cash
Flow, Price/Sales, Price/Earnings-to-Growth Ratio, Dividend Yield and Return on Equity. Numbers in
brackets denote the countrys weight in MSCI EM. Only showing countries with a weight above 2%.
Source: Investment Strategy Group, Datastream, Bloomberg.

95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14
Data as of Q3 2014.
Source: Investment Strategy Group, Datastream.

Emerging Market Equities:


Out of Favor But Not Out of the Woods

worse than the 8% gain experienced by developed


market equities, and representing the fourth
consecutive year emerging markets have lagged.
After years of underperformance culminating
in a perfect storm of headwinds last year, emerging
market equities are naturally on the radar screen of
many contrarian investors. We remain circumspect
for several reasons. First, most emerging market
countries actually trade at or above their historical

Whatever could go wrong for emerging market


equities did in 2014. Monetary and fiscal policy
tightened, geopolitical risks escalated, currencies
depreciated, earnings growth disappointed,
valuation multiples contracted and investors fled.
The result was a 5% decline for the year, much

Exhibit86: 2014 Currency Returns

Every major currency across all regions depreciated against the dollar in 2014.
2014 Spot Return
G10

EM Asia

0%
-10%
-20%

-12% -13%

-8%
-10% -9%

-6% -5%

EMEA

-2% -2% -1% -1%


-4% -2%
-6% -6% -5%
-17%

-19% -18%

-15% -13%

Latin America

-6%

-8%
-11% -9%

-13% -12%

-11%

-19%

-30%
USD
Appreciation

-40%

60

Goldman Sachs january 2015

Peru

Brazil

Chile

Mexico

Colombia

Turkey

South Africa

Israel

Poland

Czech Republic

Russia

Thailand

Indonesia

Philippines

India

China

Korea

Singapore

Taiwan

Malaysia

New Zealand

United Kingdom

Canada

Australia

Switzerland

Euro

Japan

Norway

Sweden

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

Hungary

-46%

-50%

valuation levels, as shown in Exhibit84. Absolute


valuations thus do not yet provide a large enough
margin of safety to justify an overweight. Second,
the areas of undervaluation that do exist are
in fundamentally unattractive sectors, namely,
Chinese banks and Russian energy. Here, we worry
less about mark-to-market volatility, which longerterm investors should be able to endure in pursuit
of cheap assets. Instead, the risk that a portion of
ones investment could be permanently impaired is
uncomfortably high in these types of state-owned
and/or highly leveraged entities. Finally, valuations
are likely to remain under additional pressure
this year, as investors demand an even higher risk
premium for slowing growth in China, continued
geopolitical uncertainty and the prospects of the
Federal Reserve raising interest rates.
On this last point, it is worth noting that lower
valuations are fundamentally justified by the
declining profitability and increasing leverage on
display in emerging market equities in recent years
(see Exhibit85). This has resulted in not only a
lower return on equity, but a lower-quality return
as well. With margins unlikely to rebound this year
given rising wages, higher input costs and excess
capacity in many industries, earnings growth will
likely mirror the pace of sales growth; both are
expected to expand around 5% this year.
Combining our views on multiples and earnings
with a dividend yield of 2.8% results in total return
potential of around 5%. While such a return would
fall below the historical average return of 12%
for emerging market equities, it is positive enough
to remain attractive in a world where returns are
generally low across all asset classes. Thus, we
recommend investors stay at their strategic weight
in emerging market equities.

Exhibit87: Projected Central Bank Balance Sheets

Diverging growth paths are prompting very different


monetary policies.
Balance Sheet % of GDP
100%

Forecast
91%

Federal Reserve

90%

ECB

80%

BoJ

70%
60%
50%
40%
30%

27%

20%

19%

10%
0%
Dec-03

Dec-05

Dec-07

Dec-09

Dec-11

Dec-13

Dec-15

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

2015 Global Currency Outlook

Of the various themes that influenced global


currency markets during the course of 2014,
the hegemony of the dollar was surely the most
dominant. As shown in Exhibit86, the dollar
appreciated against every major currency last year,
a remarkable feat. The double-digit declines of
both the euro and the yen in the final half of last
year were particularly noteworthy, having been
exceeded in less than 10% of the rolling six-month
periods since the 1970s.
These sharp moves reflect both a widening of
the once-narrow growth differential between the
US and other G-10 countries and a narrowing of
the once-wide gap between the US and emerging
markets. Not surprisingly, these divergences are
necessitating very different
monetary policies, as seen in
Exhibit87. We expect this
Of the various themes that influenced
interplay between growth and
policy, as well as the shifts in
global currency markets during the
cross-border flows it engenders,
course of 2014, the hegemony of the
to drive further currency
dollar was surely the most dominant.
divergences in the year ahead.
We next discuss our US
dollar view, as well as our
outlook for the major developed
and emerging market currencies.

Outlook

Investment Strategy Group

61

Exhibit88: US Dollars Real Effective Exchange Rate

Exhibit89: Eurozone Portfolio Flows

The dollar is still well below its historical valuation.

Eurozone investors are switching to higher-yielding offshore


alternatives.

Z Score

Billion
250

Foreign Purchases of Eurozone Assets


Eurozone Purchases of Foreign Assets
Net Portfolio Flows

200
3

150

Portfolio Inflows

100

50
1

0
-50

0
-0.7
-1

-100
Portfolio Outflows

-150

-2

-200
73

76

79

82

85

88

91

94

97

00

03

06

09

12

Jun-12

Sep-12

Dec-12 Mar-13 Jun-13

Sep-13

Dec-13 Mar-14 Jun-14

Sep-14

Data as of December 2014.


Note: Z-Score is calculated based on data since 1973.
Source: Investment Strategy Group, Bloomberg.

Data through Q3 2014.


Source: Investment Strategy Group, Bloomberg.

US Dollar

Euro

It might come as a surprise that the dollar remains


attractively valued relative to most other G-10
currencies despite last years 12.5% trade-weighted
gain. But as shown in Exhibit88, the dollar is still
almost one standard deviation, or 7%, below its
historical valuation relative to the currencies of
the US trade partners, after adjusting for inflation.
This undervaluation provides ample scope for
continued dollar strength.
Valuation is not the only tailwind for the
greenback. The dollar is benefiting from the US
mix of above-trend growth, normalizing monetary
policy and capital inflows. This combination
stands in stark contrast to the weaker growth
and looser policy of other developed countries, as
well as the slowing growth and capital outflows
plaguing many emerging markets. Crucially, this
divergence between the US and other countries
reflects broad macroeconomic currents that are
unlikely to shift quickly. Moreover, the dollar has
the advantage of a steady 61% share of world
central bank reserves, as well as a commanding
share of foreign exchange market turnover (about
87% in 2013). As a result, we expect the US dollar
to remain well-bid in the year ahead, particularly
against the euro and yen (see also Section I,
Overweight the Dollar).

Last years 12% decline against the US dollar


marked a notable reversal of fortune for the euro,
which had been the best-performing G-10 currency
on a trade-weighted basis just the year before. Part
of this weakness no doubt reflects the fact that
the tailwinds from the 2013 end of the Eurozones
two-year-long recession and receding sovereign
crisis fears have now largely run their course,
particularly with political risk on the rise again. But
these are not the primary drivers.
Instead, 2012s unequivocal commitment by
ECB President Mario Draghi to do whatever it
takes marked a material shift in ECB rhetoric and
a watershed moment for the euro. Notably, the
ECB is poised to make good on this commitment
in 2015 by pursuing corporate and sovereign bond
purchases. Already, Eurozone sovereign yields are
plumbing new lows in anticipation, as is the euro.
This dramatic shift in central bank policy has
created a self-reinforcing headwind to the euro.
Lower Eurozone sovereign yields are driving
domestic investors to sell their euro-denominated
assets to buy higher-yielding offshore alternatives
(see Exhibit89). Meanwhile, foreign investors
fearful of further euro depreciation increasingly
are hedging their purchases of Eurozone assets by
shorting the euro (i.e., selling euros). With the ECB
just on the cusp of beginning quantitative easing,
this downward pressure is likely to persist.

62

Goldman Sachs january 2015

In short, although euro depreciation has been


swift, further downside seems likely. Consider that
the euro is only fairly valued against the dollar
despite the significant differences between US and
Eurozone growth and monetary policy. As a result,
we continue to recommend clients be short the
euro relative to the dollar.
British Pound

The pound was not spared from the dollar advance


last year, falling 6% relative to the greenback.
We expect this weakness to continue for several
reasons. First, the pound is about 9% overvalued
relative to the US dollar. Second, the market is now
expecting the Federal Reserve to raise interest rates
ahead of the BOE, which will widen their policy
rate differential. Finally, we are mindful that rising
political uncertainty could weigh on sterling. More
specifically, growing support for nontraditional
parties, highlighted by UKIP gaining parliamentary
seats, and the prospect of an EU referendum in
2017 may keep sterling under pressure.
Notwithstanding its shortcomings compared
to the dollar, sterling actually looks attractive
relative to other developed market currencies, such
as the euro and yen. The UK is among the most
popular destinations for European investors and
should enjoy portfolio inflows driven by Europeans
in search of yield. In fact, the high likelihood of
quantitative easing by the ECB may hasten this
trend. Moreover, long positioning in sterling is light
and monetary policy expectations have receded
over the last six months, setting a lower hurdle
for upside surprises. Finally, within the G-10, our
expectation for above-average growth in the UK,
of 2.02.75% this year, should provide support to
the currency.
In short, while we expect the pound to weaken
relative to the dollar, we think the euro and yen are
better vehicles to express our bullish dollar view.
Yen

After a remarkable 56% decline and three


consecutive years of losses, the yens descent may
appear exhausted. After all, the market is well
aware of how significantly Japans narrow basic
balance has deteriorated (see Exhibit90), as well as
how aggressively the BOJ is expanding its balance
sheet. But while these forces help explain the yens

Outlook

Investment Strategy Group

Exhibit90: Japans Narrow Basic Balance

A deteriorating current account and capital outflows have


weighed on the yen.
% of GDP

Current Account
Foreign Direct Investment
Narrow Basic Balance

6%
5%
4%
3%
2%
1%
0%
-1%
-2%
-3%
-4%
04

05

06

07

08

09

10

11

12

13

14

Data through Q3 2014.


Note: Current account and foreign direct investment data are four-quarter averages.
Source: Investment Strategy Group, Haver.

current level, the next phase of depreciation will


also be driven by a weakening in net portfolio
capital flows.
Keep in mind that Japans GPIF is the worlds
largest public pension, with $1.1 trillion in
total assets, the bulk of which sits in domestic
government bonds and other low-yielding, yendenominated assets. In October of last year, GPIF
indicated that it would begin rebalancing its
portfolio in April 2015 with a goal of shifting a
quarter of the portfolio out of domestic bonds and
into foreign assets on an unhedged basis. In other
words, we estimate these pensions will need to sell
$100-$150 billion of yen to purchase these foreign
assets, exerting significant downward pressure on
the currency.
While GPIF has not provided a specific time line
on how long this rebalancing will take, we believe
it will unfold over 1824 months. Consequently,
the yen will likely remain under pressure during
this time period. Of course, some investors are
concerned that ongoing yen depreciation could
spark another bout of currency wars. As we
wrote in last years Outlook, we see such an
outcome as unlikely, particularly in light of Federal
Reserve Vice Chairman Stanley Fischers recent
comment that Japanese policy actions have been
appropriate.45 Indeed, while the depreciation

63

Exhibit91: Yen vs. US Dollar

Exhibit92: Emerging Market FX Valuation

Despite its rapid weakening, the yen is trading near its


30-year average.

In spite of cheap valuations, emerging market currencies face


headwinds in 2015.

USDJPY Spot Rate

Deviation from Fair Value

275

10%

USDJPY
Average

250

5%

225
JPY
Depreciation

200

0%

175

-5%

150

-10%

125
100

EM Currencies
Undervalued

-15%

75
50

-20%
84

86

88

90

92

94

96

98

00

02

04

06

08

10

12

14

08

09

10

11

12

13

14

Data as of December 31, 2014


Source: Investment Strategy Group, Bloomberg.

Data as of December 31, 2014.


Note: Average of 5-year moving average, GSDEER and FEER misalignments.
Source: Investment Strategy Group, Bloomberg, Goldman Sachs Global Investment Research, Peterson
Institute for International Economics.

has been rapid, the yen is trading only around


the average of its 30-year trading range (see
Exhibit91).
Therefore, we continue to recommend clients be
short the yen relative to the dollar.

At the same time, we do not find a tactical short


appealing. Valuations have become much more
attractive, with the group now 12% undervalued
and about three standard deviations cheaper than
at any point in the last five years (see Exhibit92).
In fact, many emerging market currencies now
trade beneath their global financial crisis lows.
Moreover, their relative yield differential to the US
dollar has increased to 5.6%, about 1.8 percentage
points higher than levels seen before the taper
tantrum. At these levels, yield-hungry investors are
apt to take a look.
In light of these opposing drivers, we do not
find a tactical view on the overall asset class
attractive. Instead, we recommend a more granular
focus on country-specific opportunities, such as
our continued overweight to the Indian rupee. Not
only does the currency benefit from ongoing capital
inflows on the back of the new Narendra Modi
governments structural and fiscal reforms, but it
also has an enticing 6.3% yield. In addition, Indias
current account deficit continues to improve,
reflecting lower oil and gold imports.
Against this, we recommend an underweight
to the Australian dollar, which should struggle
in the face of a stronger US dollar, a sizable drop
in the price of its commodity exports (especially
iron ore to China) and expected rate cuts by its
central bank.

Emerging Market Currencies

Emerging market currencies were not immune


to dollar strength in 2014, depreciating about
13% against the dollar. Of course, this aggregate
return belies significant dispersion, as the strongest
emerging market currency was basically flat while
the weakestthe Russian rublewas down a
staggering 46% against the dollar.
Despite their collective underperformance, we
remain cautious on emerging market currencies.
As last year reminded us, continued dollar strength
represents a stiff headwind to the group. Moreover,
rising US interest rates will weigh on countries with
large external financing needs (e.g., Turkey and
South Africa), as evidenced during 2013s taper
tantrum. We are also wary about the tendency
of independent central banks in countries like
Chile and Mexico to use currency depreciation as
a shock absorber against external jolts. Finally,
the Russian ruble, which is 4.3% of the emerging
market local debt currency index, should remain
under pressure in the face of lower oil prices and
ongoing Western sanctions.46

64

Goldman Sachs january 2015

Exhibit93: Fixed-Income Returns by Asset Class

Exhibit94: Change in 10-Year Yield Required to


Offset One Year of Coupon Income

Last year brought nearly across-the-board strength.

A very small change in yields would generate a loss for most


longer-duration bonds.
2014 Total Return

Bps

20%

40

17.2%
13.8% 13.4%

15%
10%

10.7%
7.4%
4.7%

5%

3.6%

30
2.5%

1.5%

1.3%

24

0%

21
20

-5%

20

19

US Inflation (%YoY) *

Bank Loans

US Corporate High Yield

US Treasury TIPS

US Muni 1-10 Year

EM US Dollar Debt

10 Year US Treasury

Germany 7-10 Year (Local)

Muni High Yield

EMU 7-10 Year (Local)

-10%

EM Local Debt

-5.7%

18

10

0
US

Italy

Canada

UK

Spain

France

Germany

Japan

Data as of December 31, 2014, except where indicated.


Source: Source: Investment Strategy Group, Bloomberg. See endnote 47 for list of indexes used.
* US inflation data is through November 2014.

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

2015 Global Fixed Income Outlook

of course go lower still, todays already-depressed


levels set a practical limit on their capacity to do
so. This is particularly true at a time when abovetrend growth in the US and the long-awaited
arrival of the Federal Reserve rate hikes are likely
to put upward pressure on Treasury yields.
Against this backdrop, we recommend that
investors favor credit over duration risk by
tactically underweighting a portion of their
investment-grade fixed income allocations and
overweighting US corporate high-yield credit.
Gradually rising interest rates imply negative
returns for US investment-grade fixed income and
global 10-year government bonds, because todays
scant yields are not sufficient to offset falling
prices. At the same time, we see scope for US credit
spreads to decline as stronger US growth keeps
default rates at below-average levels.
That said, low prospective returns should
not lead investors to completely abandon their
investment-grade bond allocations. As last year
reminded us, these bonds serve a vital strategic
role in portfolios, both providing a hedge against
deflation and generating income. Therefore,
investors should not completely abandon their
investment grade bond allocation in search of
higher yields.
In the sections that follow, we will review the
specifics of each market.

The fixed income market contained what was


arguably the most unexpected financial development
of 2014: contrary to almost universal expectations
of a further increase, rates instead declined across
the globe. This reversal continued a trend now
all too familiar to fixed income investors, as last
years unexpected bond rally reversed much of the
surprising selloff from one year earlier. Of course,
last years U-turn was a more welcome development
for bond investors, as nearly every fixed income
category posted a positive return (see Exhibit93).47
Nevertheless, an encore is unlikely in 2015. We
begin the year with interest rates already at or near
all-time lows across the globe. The 10-year German
Bund, for example, yielded just 0.54% at the end of
last year, the lowest level ever in federal Germanys
history. From here, an increase in yields to just
0.60%, or 6 basis points higher, would generate
a capital loss sufficient to offset an entire years
worth of interest. As shown in Exhibit94, 10-year
sovereign bonds around the globe offer a narrow
margin of safety.
In addition, medium-term government bond
yields stand broadly below prevailing inflation
in much of the developed world, implying that
investors are literally paying their governments in
real terms to borrow from them. While yields could

Outlook

Investment Strategy Group

65

Exhibit95: Market-Implied Federal Funds Rate Path


Over Time

The market has prematurely expected Fed rate hikes many


times in recent years.
1.8%
Fed Funds (5-day Average)

1.6%

12/31/2011
1.4%

12/31/2012
12/31/2013

1.2%

12/31/2014

1.0%
0.8%
0.6%
0.4%
0.2%
0.0%
Dec-11

Dec-12

Dec-13

Dec-14

Dec-15

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg, BCA.

US Treasuries

Last year was a study in contrasts for US Treasuries.


While bonds with maturities of less than five years
saw their yields rise, the opposite was true for
longer-duration Treasuries, with many of their yields
approaching historical trough levels. For example,
the 30-year Treasury yield briefly touched 2.67% in
October, merely 22 basis points above its all-time low.
These differences reflected two opposing forces.
On the one hand, the likelihood of near-term
Federal Reserve interest rate hikes on the back of
an improving US economy pushed yields up at
the short end of the curve, as these rates primarily
reflect market expectations of the federal funds rate
in the future. On the other hand, yields at the long
end were pressured by concerns about US trend
growth, loose monetary policy abroad, lower oil
prices, purchases by the Federal Reserve through
October of last year, purchases by foreign investors
in search of yield, purchases by US banks to meet
regulatory capital requirements, reduced Treasury
supply given the improving US budget deficit and
less issuance given lower mortgage demand.
While many of these drags on longer-dated yields
are unlikely to vanish this year, we do expect their
collective impact to wane. Above-trend US growth
should temper concerns about secular stagnation,
while also giving a boost to the housing market and
hence mortgage credit supply. Moreover, the end of
QE means that the Federal Reserve will no longer

66

Goldman Sachs january 2015

be purchasing bonds. Meanwhile, the stabilizing oil


prices we expect should steady inflation expectations.
US banks are also rapidly approaching their needed
capital thresholds well ahead of schedule, which
removes one large source of incremental demand.
But perhaps most importantly, we expect the
Federal Reserve to begin hiking interest rates this
year. After repeated false dawns that have left
market participants feeling a bit like the main
characters in Samuel Becketts absurdist play
Waiting for Godot, the actual commencement of
hikes after six years on the zero bound is likely to
push yields gradually higher across the curve. An
adjustment in market expectations on the pace of
Federal Reserve tightening could hasten this move,
particularly since that assumed pace is slow relative
to history, current US fundamentals and even the
FOMCs own communications.
As shown in Exhibit95, market prices suggest
the Federal Reserve will hike rates 21 basis points
per quarter after liftoff in the third quarter of 2015.
However, this is much lower than the 73 basis
points suggested by historical tightening cycles,
the 30 basis points suggested by models that relate
macroeconomic fundamentals to Federal Reserve
policy and the FOMCs own projection of 35 basis
points. Notably, the historical Federal Reserve
projections over the last three cycles have tended
to underestimate the actual pace of tightening by
more than 25 basis points per quarter. As a result,
risks seem skewed toward a faster Federal Reserve
tightening pace relative to what markets are pricing.
Our view that interest rates will rise has
important investment implications. As shown earlier
in Exhibit94, it takes only a 24-basis-point increase
in 10-year Treasury yields today to generate a
capital loss sufficient to offset an entire years worth
of interest income. Consequently, our expectation
that the 10-year yield will rise to a range of 2.25
3% implies a negative expected return of 0.9% for
an intermediate-duration strategy in 2015.
Treasury Inflation-Protected Securities (TIPS)
also benefited from declining interest rates in 2014,
but to a lesser degree than nominal Treasuries.
TIPS posted a 3.6% return, a full five percentage
points below that of nominal Treasuries of similar
maturity. The inflation-protection feature of TIPS
was a drag on returns as inflation expectations
declined with oil prices late in the year. In fact,
five-year market-implied inflation ended the year
at 1.2%, its lowest level since 2009. While market-

Exhibit96: Intermediate Municipal Bond Return


Projections

Rising interest rates imply near-term losses but ultimately


better reinvestment yields.
%Ann.
3%

2.7%

2%
1.3%
1%

0%

-1%

-0.7%
First 2 Years

Last 3 Years

5 Years

Data as of December 31, 2014.


Source: Investment Strategy Group.

implied inflation should ultimately rise with


stronger GDP growth and normalizing inflation
trends, the resulting boost to TIPS returns is unlikely
to fully offset the impact of rising interest rates.
Based on this outlook, we recommend investors
underweight intermediate-dated Treasuries by
converting a portion of them to cash, available
for use either to fund tactical tilts with more
potentially attractive prospects or as a means of
reducing the portfolios target duration. Given
TIPS unfavorable tax treatment (discussed at
length in our 2011 Outlook) and unattractive
current valuations, we suggest clients with taxable
accounts avoid TIPS altogether. Tax-exempt
investors should underweight TIPS, despite the
hedge they provide to real purchasing power.
As noted in last years Outlook, we should not
confuse an underweight of Treasuries with a zero
weight. As demonstrated over the last few years,
Treasuries were one of the few asset classes to
hedge effectively against flaring sovereign concerns,
periods of deflation, recessions and unforeseen
geopolitical risks. Thus, clients should maintain a
sufficient allocation to bonds in the sleep well
portion of their portfolios.
US Municipal Bond Market

After registering its first annual loss in almost


two decades in 2013, the intermediate municipal
bond market made a notable about-face last year,

Outlook

Investment Strategy Group

outperforming US Treasuries and corporate bonds


with a total return of 4.7%. These strong gains
were precipitated by a confluence of supportive
factorsfalling interest rates, below-average
issuance, improving fundamentals and abating
bankruptcy fearsthat stood in contrast to the
perfect storm that plagued 2013. Moreover,
whereas 2013 featured the largest municipal
bankruptcy on record (Detroit), last year saw
credit rating upgrades of 2014s two largest
municipal issuers (New York and California). Not
surprisingly, investors flocked back into municipal
bond mutual funds, with last years $27 billion of
inflows offsetting nearly half of 2013s $58 billion
in outflows.
Unfortunately, conditions are unlikely to
remain as favorable this year. For one thing,
last years outperformance has left municipal
valuations elevated relative to Treasuries. Indeed,
the incremental 38 basis points of after-tax yield
investors currently earn for owning five-year AAArated municipal bonds instead of Treasuries stands
well below the 56-basis-point average since 2000
and at a level that has been lower 34% of the time
since 2000. Put differently, the five-year ratio of
municipal bond yields to Treasury yields today
stands at 80% (municipal bond yields are lower as
a result of their tax benefits), below the average of
85% since 2000.
With spreads offering little buffer to absorb
the backup in Treasury yields we expect this year,
municipal yields are likely to rise along with those
of Treasuries. The resulting decline in municipal
bond prices is likely to eclipse the historically low
level of coupon income. For example, we expect
intermediate municipal bonds would generate
a 0.7% loss this year if their yields rose in line
with our 10-year Treasury yield forecast. This
assumes their spreads to after-tax yield Treasuries
widen close to the long-term average previously
mentioned.
Unfortunately, the risks to these return scenarios
are skewed to the downside. Concerns about higher
rates could trigger mutual fund outflows, as we
saw in similar episodes in 1994, 1999, 2004 and
the taper tantrum in 2013. As was the case then,
such outflows can result in exaggerated moves
within the municipal market. The only bright side
of rising interest rates for municipal bond holders
is that ultimately they will be able to reinvest at
higher yields (see Exhibit96).

67

Exhibit97: Implied Default Rates in the Year Ahead

Exhibit98: Default Rates for High-Yield Energy

Todays high-yield energy spreads imply oil averages around


$50, well below our forecast of $60$80.

Current high-yield spreads already discount an energy


default cycle.

Implied Default Rates


Over the Next Year

Annual Rate (%)


25%

10%

9.3%
8.5%

20%

8%
6.0%

6%

Current Implied

22.7%

Historical Average of All Years


Historical Average of Only Default Years

10.6%
4%

3.9%

10.2%

10%
6.5%
5%

2%

17.1%

15%

3.0%

10.5%

5.6%

1.9%

0%

0%
Current Market Implied Bottom-up Assuming Bottom-up Assuming Bottom-up Assuming
$70 Crude
$60 Crude
$50 Crude

Ba

Caa-C

Rating

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg, Barclays, Moodys.

Consequently, we recommend clients convert a


portion of their high-quality municipal bonds into
cash, which can then be used to fund tactical tilts or
simply held as a way to reduce the target duration
of the portfolio. Our main concern is rate risk and
not credit risk, and we continue to expect defaults
among higher-quality municipal bonds to be rare.
We also would not recommend a zero weight for
the same reasons we mentioned for US Treasuries.
In contrast, clients should remain fully invested
in high-yield municipal bonds. Despite their
impressive 13.8% return in 2014, high-yield
municipal bond yields relative to US Treasuries stand
at a 3.2% spread today, much more attractive than
their long-term average of 2%. Given improving US
growth, we expect todays expensive valuations will
offset the potential hit to prices from rising rates
despite these bonds long 10 year duration. In our
base case, high-yield municipal bonds will post lowsingle-digit positive returns in 2015.

This sharp uptick in volatility reflects a host of


concerns. Existing angst about deteriorating credit
quality, low absolute yields and increasingly lax
covenants has been reinforced by fresh worries
about the proximity of Federal Reserve rate hikes
and the impact of last years dramatic decline in oil.
The fact that energy and mining bonds represent
about a fifth of the benchmark index today
nearly double their weight a decade agoonly
exacerbates anxiety about commodity exposure.
Given this abundance of worries, and
considering high-yield bonds have delivered six
consecutive years of gains, the desire to sell is
certainly understandable. Nevertheless, we believe
it is premature. While energy defaults are no
doubt set to rise, we expect the increase to be less
than what their bond spreads now indicate. Keep
in mind that the market is currently implying
annual energy defaults of more than 8%, well
above the sectors 4.6% long-term average and
current trailing default rate of just 1.6%. Crucially,
our bottom-up analysis of the high-yield energy
universe suggests such a high default level would
require oil prices to average around $50 per
barrelover the next two years, well below our
forecast of $6080 (see Exhibit97). Examining
energy bonds at the credit-rating level tells a
similar story, with B and Caa-C spreads already
consistent with historical energy default cycles (see
Exhibit98). While Ba energy bond spreads have

US Corporate High-Yield Credit

To the casual observer, last years 2.5% high-yield


return seems pedestrian enough, until one considers
the path that led there. From September to midDecember, total returns plunged more than 600
basis points, briefly dipping into negative territory
for the year. Only a rally in the last two weeks of
2014 salvaged what would have otherwise marked
high-yields first loss in five years.

68

Goldman Sachs january 2015

Exhibit99: Characteristics of Bank Loan and HighYield Bond Issuance

The stock of existing debt today is of a much higher quality


than at the peak of the last credit cycle.
Share of New Issuance
100%

3 Years Ending in 2007


3 Years Ending in 2014

75%

Exhibit100: Refinancing Among Low-Rated Issuers

Despite recent deterioration, the rate of refinancing today


stands significantly above 200708 levels.
Refinancing as a % of
Lower-rated Issuance
80%

72%

53.4%
50%

25%

12.5%

55% 54%

50%

42%
33% 34%

30%
26.5%

24.4%

59%

54%

40%

24.7%

68%

60%

60%
58.8%

72%

72%

70%

20%

34%
26%

14%

18%

17%

16%

9% 8%

10%

2014

2013

2012

2011

2010

2009

2008

2007

2006

2005

2004

2003

2002

2001

2000

1999

1998

Refinancing

1997

Low-Rated Companies

1996

Leveraged Buyouts / M & A

1995

0%

0%

Data as of December 31, 2014


Source: Investment Strategy Group, JP Morgan.

Data as of December 2014.


Source: Investment Strategy Group, JP Morgan.

scope to widen based on historical cycles, note that


today over half of these bonds are issued by betterpositioned midstream companies and refiners.
These high default levels appear even more
out of kilter considering these firms hedged about
53% of their oil exposure for 2015 before last
years sharp drop. Moreover, there is little risk of
refinancing-related defaults, with just 1.2% of
existing debt maturing in 2015. Even if capital
markets were to become less accommodating,
there is almost $1.2 trillion in private equity that
could become available to distressed firms with
unique assets or superior cost positions. Finally, the
prevalence of lax covenants could paradoxically
afford energy firms much-needed flexibility to
sidestep default. Thus, we believe there is scope for
energy bond spreads to tighten as realized defaults
come in less than feared.
Of equal importance, trouble in the oil patch
has created value elsewhere in high-yield bonds. In
the most recent episode, portfolio managers facing
a paucity of bids for their distressed energy credits
instead sold their more liquid bonds in other
sectors to raise cash. As a result, spreads widened
across the high-yield universe, with the market
now implying 3.2% nonenergy defaults, a notable
acceleration from todays 2% trailing rate.
We find this indiscriminate spread widening
unjustified for several reasons. First, lower oil
prices foster growth in other areas of the US

economy, which should directly benefit the credit


profile of many nonenergy industries that generate
the majority of their sales domestically. Moreover,
leading indicators of defaults, such as Moodys
liquidity and covenant stress indexes, suggest few
speculative-grade companies are experiencing
liquidity problems or are at risk of breaching
financial covenants. Notably, both of these indexes
began to deteriorate in advance of the last default
cycle yet today stand near their all-time lows.
Second, as was the case for energy, there is
little risk of refinancing-related defaults, with just
5% of the total $2.5 trillion of leverage credit
outstanding maturing in the next two years.
Similarly, only 3.5% of leveraged buyout debt is
coming due over this period.48 Third, the stock
of existing debt is of a much higher quality today
than at the peak of the last credit cycle, reflecting
fewer lower-rated issuers and more refinancingdriven issuance (see Exhibit99).
This last point is important, as it is the credit
characteristics of the aggregate pool of debt that
ultimately dictate the level of defaults. While there
has been some deterioration in credit quality
and use of proceeds over the last year, this inflow
remains a small part of the existing stock of debt.
In addition, it is still higher-quality issuance than
that seen at the peak of the last credit cycle (see
Exhibit99 and Exhibit100).

Outlook

Investment Strategy Group

69

Exhibit101: High-Yield Spreads and Default Rates

Exhibit102: High-Yield Credit Performance During


Periods of Rising Rates

Todays high-yield spreads stand well above periods with


comparably low defaults in the past.
Trailing Default Rate

Spread (bps)
2500

High-yield has historically outperformed investment-grade


bonds during episodes of rising rates.

High Yield Spread


Trailing Default Rate (Right)

2000

5%

14%

4%

12%

3%

10%

1500

8%
1000

6%
4%

500

Average Return

16%

% of Time Positive
100%

75%

2%
50%
1%
0%

Average Total Return During Episodes of Rising Rates*


% of Time Positive (Right)

-1%

25%

2%
-2%
0%

0
94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09 10 11 12 13 14

0%
Inv. Grade Fixed
Income (IGFI)

High Yield

High Yield - IGFI


Difference

Bank Loans

Bank Loans IGFI Difference

Data as of December 2014.


Source: Investment Strategy Group, Barclays, Moodys.

Data as of December 2014.


Source: Investment Strategy Group, Barclays, Credit Suisse.
* Defined as 5-year Treasury yield rising more the 70 basis points over 3-month period.

While we are mindful of the other concerns


around high-yield bonds, including todays
low absolute yields and potential for rising
rates, these worries dont undermine the case
for being overweight, in our view. Todays low
absolute yieldsoften cited as a sign of investor
exuberancemainly reflect low risk-free Treasury
rates. By contrast, high-yield spreadswhich
represent investors compensation for assuming
credit riskstand more than 200 basis points
above their previous trough, as well as above
other periods of low defaults in the past (see
Exhibit101).
Meanwhile, rising rates usually reflect an
improving economy, which is generally supportive
of credit quality and therefore lower defaults.
For this reason, high-yield bonds may be a better
interest rate hedge than many investors realize. In
fact, high-yield bonds generated a positive return
67% of the time during historical interest rate
backups, and one that exceeded the performance
of investment-grade bonds 83% of the time (see
Exhibit102). Bank loans did even better. This
relative performance is noteworthy, as our highyield overweight is funded out of investment-grade
fixed income.
In short, we think a combination of improving
US growth and stabilizing oil prices will keep
defaults lower than the market currently expects,

allowing spreads to compress. While high-yield


credit is unlikely to duplicate the remarkable
risk-adjusted returns it has achieved in the postcrisis period, last years widening of spreads has
nonetheless paved the way for further gains in
2015. After all, high-yield bonds have generated a
positive return in 27 of the last 32 years; this year
should be no exception. Therefore, we recommend
clients remain overweight.

70

Goldman Sachs january 2015

Eurozone Bonds

The fact that Eurozone bonds were embroiled


in an existential sovereign crisis just a few years
ago made their stellar returns last year all the
more striking. Indeed, European bonds posted the
highest fixed income returns in 2014, as interest
rates dropped sharply in each of the continents
largest economies. Consider that Germanys 10year Bund yield fell 139 basis points to 0.54%, an
annual decline that has been exceeded only 11%
of the time since 1977. Yields in Spain, Italy and
France fell even further, by 254 basis points, 224
basis points, and 173 basis points, respectively
(see Exhibit103). In aggregate, 10-year Eurozone
bonds with a maturity of 710 years returned
17.2%, marking their highest calendar-year return
with lowest volatility since 1999.

Exhibit103: Change in Eurozone Yields

Yields fell dramatically across the Eurozone in 2014, leading


to strong bond gains.
Change in Yield (bps)
0
-50
-100
-150

-139
-173

-200

-224

-250

-226
-254

-300
-350

-344

-400
Germany

France

Italy

Spain

Portugal

Ireland

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

The numerous drivers of these declines


including sluggish growth, mounting deflation
risks and loose ECB policyare likely to remain
in place and keep yields near their current levels in
2015. Even so, there are several sources of upside
risk. First, the commencement of ECB sovereign
quantitative easing could reduce deflation risk,
warranting a reversal of a portion of this risk
premium that has contributed to lower yields.
Second, monetary policy tightening in the US and
UK could serve to lift global rates more broadly.
Third, rising political tensions and lack of reform
could warrant higher sovereign-risk premiums,
pushing yields higher in the periphery and France.
Finally, the incremental yields of other countries
relative to the German Bund currently stand
below levels justified by their fiscal fundamentals
alone, arguing for some upward pressure on

spreads. Based on the foregoing, we expect 10-year


German Bund yields to end the year in the range of
0.51.0%, with a midpoint above todays level.
Turning to the UK, returns of 16% for the 10year gilt also benefited from falling interest rates in
2014. The 10-year gilt yield fell by 124 basis points
from 3.00% to 1.76% as inflation disappointed
expectations, BOE rate hikes were pushed back
and broader global interest rates fell. Even so, the
BOE is likely to raise interest rates along with the
Federal Reserve this year, which we believe will
lead to higher gilt yields. More specifically, we
expect 10-year gilt yields to gradually rise to a
range of 22.75% by year-end.
Given this outlook, we remain underweight
UK and Eurozone government bonds. Yields are
unusually low, which reduces the margin of safety.
Indeed, as shown earlier in Exhibit94, German
10-year Bund yields would need to rise by only
about six basis points to wipe out an entire year of
carry. The equivalent rise for Italian bonds is only
21 basis points. That said, clients should retain
some exposure to German Bunds and other highquality bonds in the sleep well portion of their
portfolios. These high-quality bonds would all but
certainly do well if the risk of Eurozone recession
and deflation were to increase.
Emerging Market Local Currency Debt

Emerging market local currency debt (EMLD)


declined 5.7% in 2014, its second consecutive
yearly loss. This mid-single-digit decline masked
a sharp 12.8% drop in the currency component
of total return, the largest since the financial crisis
and one that coupon and principal payments
were able to only partially offset. The euro and
Russian ruble were notable contributors to this
currency rout.
While we expect another year of volatility in
EMLD, the asset class should be able to reverse
the string of losses with a lowto mid-single-digit return in
2015. To be sure, currencies
Sluggish growth, mounting deflation risks
are likely to remain a drag
in a strong dollar world,
and loose ECB policy are likely to remain in
particularly for the 40% of the
place and keep Eurozone bond yields near
index that is valued against the
their current levels in 2015.
euro. Even so, valuation should
provide an offset, as emerging

Outlook

Investment Strategy Group

71

Exhibit104: EMLD Cumulative 2014 Return

Exhibit105: Commodity Index Performance

Dollar strength was a key driver of EMLD losses last year, as


euro and yen investors had gains.

Commodities underperformed US equities again in 2014 for


the seventhconsecutive year.
S&P GSCI Return S&P 500 Return

EMLD 2014 YTD


Cumulative Return
15%

80%
USD
EUR
JPY

10%

60%
7.6%
7.4%

5%

40%
20%
0%

0%

-20%
-40%

-5%

-5.7%

-10%
12/31/13

Commodities
underperform

-60%
-80%

03/31/14

06/30/14

09/30/14

12/31/14

1990 1992 1994 1996 1998 2000 2002 2004 2006 2008 2010 2012 2014

Data as of December 31, 2014.


Source: Investment Strategy Group, Datastream, JP Morgan.

Data as of December 31, 2014.


Note: Based on S&P GSCI and S&P 500 total return indexes.
Source: Investment Strategy Group, Bloomberg.

market currencies are already weaker than their


2009 lows and about 12% undervalued relative to
their history.
Furthermore, EMLD could find some support
among euro- and yen-based investors, who because
of moves in their home currency last year actually
experienced EMLD gains of 7.4% and 7.6%,
respectively (see Exhibit104). These investors
should continue to be attracted by EMLDs 6.5%
yield, particularly in Europe, where the rate
differential is at a 12-year high.
Moreover, central bank policy could further
support the asset class. With lower inflation on the
back of falling oil prices, emerging market central
banks in economies with weak growth have more
room to cut rates or at least remain on hold. In
turn, this provides some counterbalance to the drag
on bond prices arising from higher US rates.

Of course, Russia remains a source of risk this


year despite the fact that its index weight more
than halved to 5% in 2014. With no end in sight
for western sanctions over the frozen conflict in
Ukraine and low oil prices likely to persist, Russian
currency and local bonds will likely remain under
pressure from large-scale capital outflows.
In sharp contrast to the above, emerging
market dollar debt (EMD) was among the betterperforming bond markets in 2014. However, the
same seven-year duration that boosted its return in
last years Treasury rally will work against it this
year given our expectation of rising rates. While its
yield has climbed to 5.6% recently, EMD remains
unattractive given the still-uninspiring spreads
on better credits in Mexico and Asia, escalating
risks of a downgrade in Russia and Brazil, the

Exhibit106: Commodity Returns in 2014

Last year extended the streak of lackluster commodity returns, with four out of five subcomponents declining.
S&P GSCI

Energy

Agriculture

Industrial metals

Precious metals

Livestock

-6%

-6%

-13%

-1%

-11%

20%

Spot price return

-34%

-45%

-8%

-6%

-4%

14%

Excess return*

-33%

-44%

-11%

-7%

-4%

14%

Spot price average, 2014 vs. 2013

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.
* Excess return corresponds to the actual return from being invested in the front-month contract and differs from spot price return depending on the shape of the forward curve. An upward-sloping curve
(contango) is negative for returns while a downward-sloping curve (backwardation) is positive.

72

Goldman Sachs january 2015

Exhibit107: Consumption Growth of Mined


Commodities

Exhibit108: WTI Oil Price Return

Oils steep year-end slide has few precedents.

China was a key driver of the commodity supercycle.


200313 CAGR

Rolling 172-Day Return

18%
16%

16%
14%

150%

China
World Ex-China

13%

12%

12%
10%

100%

11%

9%

50%

8%
6%

0%

4%
2%

2%

1%

-50%

0%
-1%

-2%

-2%

-4%
Copper

Aluminium

Tin

Current

-1%

-47%

-100%
Zinc (slab)

Steel

1984

1987

1990

1993

1996

1999

2002

2005

2008

2011

2014

Data as of 2013.
Note: Data through 2012 for steel.
Source: Investment Strategy Group, Goldman Sachs Global Investment Research, Bloomberg.

Data as of December 31, 2014.


Source: Investment Strategy Group, Bloomberg.

probability of default in Venezuela and Ukraine


in 2015 (markets already imply 42% and 32%,
respectively), and its exposure to oil exporters.
We are also not enticed by the 5.7% dollar
yield of emerging market corporate debt, as its
exposure to Russian corporates and Chinese
bankswhich represent a disproportionate share
of last years record $350 billion of issuancecurb
our enthusiasm. In fact, the Bank for International
Settlements (BIS), commonly known as the central
bank of central banks, recently cautioned that
nonfinancial corporate debt in emerging markets
was underestimated and could pose financial
stability risks.
We therefore maintain our tactically neutral
position on EMLD, EMD and corporate debt.

While the dramatic decline in oil was a


key contributor to this underperformance,
Exhibit106 makes clear that the weakness was
broad-based. We believe that in addition to
each commoditys idiosyncratic drivers, several
common macroeconomic headwinds are buffeting
commodities and will continue to do so in the
year ahead. First, the ongoing slowdown in
emerging markets, especially China, is weighing
on prices. As seen in Exhibit107, China was a
significant driver of commodity demand during
the commodity supercycle of the previous
decade. Copper is especially vulnerable on this
basis, justifying our ongoing tactical short.
Second, the stronger US dollar is also acting
as a headwind. This is particularly true for
commodities that had been bought on the premise
of dollar debasement, such as gold. Finally, strong
erstwhile investment in production capacity has
led to accelerating supply growth in markets such
as oil, as we discuss further below.

2015 Global Commodity Outlook


Few would fault commodity investors for wanting
to forget 2014. As a whole, the S&P GSCI Total
Return Index dropped 33%, its steepest fall since
the depths of the financial crisis in 2008. Unlike
the crisis, however, last years commodity rout
came despite gains in other risk assets. In fact, the
GSCI Total Return Index underperformed the S&P
500 Total Return Index by a staggering 47%, the
largest performance gap in more than 15 years
and the seventh consecutive year it has lagged, as
shown in Exhibit105.
Outlook

Investment Strategy Group

Oil: From Peak Oil to Weak Oil

Within a generally weak commodity complex,


oils sharp decline in the second half of 2014 was
a standout. From its mid-2014 peak, West Texas
Intermediate (WTI) crude oil declined 50% by
year-end, with the bulk of that decline concentrated
in the last two months of the year. A downdraft of
this same speed and magnitude has been exceeded
only three times historically (see Exhibit108).
73

Exhibit109: Brent Oil Supply and Disruptions vs. Price

Exhibit110: Global Oil Supply and Demand

Fewer global disruptions coupled with strong US production


led to an oversupplied oil market.

The current oversupply requires a supply reduction or a


demand increase to stabilize oil prices.

Brent Price (US$/bbl)


140

YoY Difference (mmbd)


1.5

mmb/d
96
Forecast

World Production
120
1.0
100
0.5

World Consumption

94
92

80

Risk of
continuing
oversupply
in 2015

90
60

0.0

40

Global Disruptions
US Crude Production
Brent Monthly Average Price (right)

-0.5

-1.0
Jan-13

Apr-13

Jul-13

Oct-13

Jan-14

Apr-14

Jul-14

88

20

86

84

Oct-14

Data through October 2014.


Source: Investment Strategy Group, US Department of Energy, Bloomberg.

What made the decline even more surprising is


that many of the reasons put forward to explain
it have been hiding in plain sight for some time.
US crude production has been growing at a
double-digit annual pace for years, while Chinese
GDP growth has been slowing since 2007.
Similarly, both Japan and the Eurozone have
struggled with below-trend growth for much of
the post-crisis period. Nor can one point solely to
dollar strength as the driver, considering that the
trade-weighted dollar had already appreciated
around 9% from its 2011 trough at the outset of
last year.
Instead, it seems a confluence of factors
precipitated the decline, among them a shift
in Saudi Arabias rhetoric and fewer supply
disruptions abroad. This last point is important,
as the impact of US crude production growth on

2005

2006

2007

2008

2009

2010

2011

2012

2013

2014

2015

Date: Data forecast through 2015.


Note: Showing an average forecast of different sources.
Source: Investment Strategy Group, IEA, OPEC, DOE, GS GIR, PIRA Energy, Energy Aspects, Barclays.

global supply was largely being offset by global


supply disruptions elsewhere for most of 2013.
As these disruptions faded by summer of 2014,
global oil supplies increased above already soggy
demand, placing downward pressure on prices
(see Exhibit109). The resulting price selloff was
accelerated by the Organization of the Petroleum
Exporting Countries (OPECs) inability to
agree on production cuts and Saudi Arabias
unwillingness to act as the traditional swing
producer. It seems Saudi Arabia has no appetite
to repeat the production cuts it undertook in
the early 1980s, which unintentionally created a
price umbrella that allowed other producers to
capture its market share.
As a result, the current oversupply requires
either a supply reduction or a demand increase to
stabilize oil prices (see Exhibit110). The modest
pickup in global GDP growth
we expect suggests the bulk of
the adjustment will be supplyMany of the fears that drove investors
based. Of course, a decrease
in production could come
toward gold as a store of valueincluding
from renewed disruptions. The
US dollar debasement and high inflation
geopolitical landscape remains
are now moving in the opposite direction.
far from stable, particularly
in the Middle East. Moreover,

74

Goldman Sachs january 2015

Exhibit111: Gold vs. US Dollar

A stronger dollar is depressing demand for gold.


Trade-Weighted
USD Index (inverted)

US$/Ounce
$2,100

50
Gold Price

$1,900

Weaker USD

Trade-Weighted USD (right)

55

$1,700

60

$1,500

65

$1,300

70

$1,100

75

$900

80

$700

85

$500

90
2006

2007

2008

2009

2010

2011

2012

2013

2014

Data as of December 26, 2014.


Source: Investment Strategy Group, Bloomberg.

low oil prices might also place vulnerable


exporters like Venezuela or Nigeria in unstable
social situations.
However, barring new disturbances or a quick
reversal in OPEC policy, we expect prices will need
to stay low long enough to discourage excessive
growth from the highest-cost producers. Because
US shale oil is among the most expensive sources
of production, and because it requires constant
drilling to offset the wells fast decline rates, the US
is likely to emerge as the new swing producer for
the oil market.
Already, the response has been marked. As of
late 2014, 22 US producers representing about
16% of US production had announced average
capital expenditure cuts of 16%, with the most
recent averaging closer to 25%. These cuts should
ultimately slow production growth, but keep
in mind that production will still be expanding
relative to last year.
Thus, with US production still rising into an
already oversupplied market, risks to oil prices
remain negatively skewed early in 2015. The
outlook improves in the back half of the year, as
the effect of reduced US production growth is met
with an ongoing improvement in global growth. As
a result, we expect oil prices to stabilize between

Outlook

Investment Strategy Group

$60 and $80 per barrel. Importantly, that range


should allow US production growth to expand at
a pace that doesnt overwhelm the global supply/
demand balance.
To be sure, risks around this forecast are high.
From a fundamental standpoint, the market is
now searching for an equilibrium price in a market
that is no longer managed by OPEC. Moreover,
shale oil is a new technology and in the absence
of a precedent, it is difficult to tell exactly how
production and costs might react to a lower-price
environment. Meanwhile, OPEC production itself
remains a wildcard, not only on the downside but
also on the upside. For example, on December22,
Saudi Arabia hinted it was ready to increase
oil production, adding yet another layer of
uncertainty.49
Given this highly uncertain backdrop, we do not
find the tactical merits of a directional bet on oil
attractive at this time. Even so, value is emerging in
oil-related equities, prompting us to recommend a
tactical tilt that provides exposure to energy stocks
with some downside protection.
Gold: Still Losing its Luster

With gold prices down just 2.1% in 2014, it is


tempting to believe the three-year, 36% price
swoon has fully run its course. After all, last years
decline was far more benign than that of many
other commodities, not to mention golds own
28% drop the prior year.
Yet such a cursory review misses the bearish
gold fundamentals that we believe are still at play.
In particular, the stronger US growth we expect
should support higher US real rates, thereby raising
the opportunity cost of holding gold. Moreover,
many of the fears that drove investors toward
gold as a store of valueincluding US dollar
debasement and high inflationare now moving
in the opposite direction (see Exhibit111). In fact,
the US fiscal situation has improved, the dollar
appreciated against every major currency last year
and inflation levels have declined along with oil
prices. Finally, three years of consecutive declines
and heightened volatility have tarnished golds
safe haven status, leading to lower investment
demand. Indeed, investment in gold bars and coins
fell 40% last year.50 Moreover, outflows from
exchange-traded funds (ETFs) continued, and with
the stockpile of gold held by ETFs still representing

75

Exhibit112: Investment Demand for Gold vs. Price

Exhibit113: Average Annual Gold Prices

Investor selling has presaged gold weakness historically.

Despite the recent weakness, gold remains well above its


long-term average.

Investment Demand
(% of Total Demand)

2014 US$/Ounce

Gold Price
(US$/ounce)

50%

$2,000

Investment Demand as a % of Total Demand


Average Annual Real Gold Price (right)

45%

$1,800

2,000

1,600

40%

$1,600

35%

$1,400

30%

$1,200

25%

$1,000

20%

$800

800

15%

$600

600

10%

$400

400

5%

$200

200

0%

$0
1977

1981

1985

1989

1993

1997

2001

2005

2009

2013

1,766

Annual Average Price


Long-Term Average
Post Bretton Woods Average

1,800

1,722

1,400
1,200

1,266

1,000
793
535

0
1871

1884

1897

1910

1923

1936

1949

1962

1975

1988

2001

2014

Data as of December 26, 2014.


Note: Real gold price based on latest CPI reading.
Source: Investment Strategy Group, World Gold Council, CPM Yearbook, Bloomberg.

Data as December 2014.


Source: Investment Strategy Group, Bloomberg.

about seven months of global production, there


is ample scope for further selling. This investor
selling is notable, as it has presaged gold weakness
historically (see Exhibit112).
The growing aversion to gold is not limited to
financial investors. Jewelry demand also slumped
8% last year, driven in part by less enthusiastic
Chinese buyers. Perhaps more telling, some gold
miners even hedged their production last year to
protect against future depreciation. And while
demand from central banks increased modestly,
the main buyers included Russia and Iraq, which
are less likely to continue these purchases as oil
revenues decline.

It is also important to note that gold prices


still have significant downside to their long-term
average prices. At $1,184 per ounce, the spot price
of gold remains well above its inflation-adjusted,
post-Bretton Woods average of $793 per ounce (see
Exhibit 113). It also stands well above the marginal
production cash cost of around $950 per ounce.
Even worse, these cash costs are being pushed
lower by falling energy prices.
Given this backdrop, we do not see gold as an
adequate substitute for the sleep well portion
of a portfolio and continue to recommend a small
tactical allocation to bearish gold strategies.

76

Goldman Sachs january 2015

2 01 5 O U T LO O K

In Closing

our view of us preeminence has served our clients well for

six years. Given that the underpinnings of this preeminence are


structural and based on deep economic, financial, human capital
and institutional advantages, we cannot foresee anything that
would cause us to abandon this view. In fact, the gap between
the United States and other key developed and emerging market
countries and regions has widened across a range of metrics. While
the US financial markets have outperformed their counterparts,
we do not believe that US preeminence has been fully discounted.
Hence, our six-year investment theme endures.
We continue to recommend clients have a core of their
portfolio invested in US assets. However, we remain vigilant
with respect to factors that might derail our 2015 economic and
investment outlook.

Outlook

Investment Strategy Group

77

Notes
1. As measured by the Chicago Board Options
Exchange Market Volatility Index (VIX).
2. Menzie Chinn and Jeffrey Frankel, Will the
Euro Eventually Surpass the Dollar as Leading
International Reserve Currency? NBER Working
Paper No. 11510, August 2005.
3. Jeffrey Frankel, The Euro Could Surpass the
Dollar within Ten Years, VoxEU, March 18, 2008.
4. Barry Eichengreen, The Dollar Dilemma,
Foreign Affairs, September/October 2009.
5. Barry Eichengreen, Why the Dollars Reign Is
Near an End, The Wall Street Journal, March
2, 2011.
6. Andrew E. Kramer, Russian Warns Against
Relying on Dollar, The New York Times, June
5, 2009.
7. See for instance Carmen Reinhart and Kenneth
Rogoff, This Time Is Different: Eight Centuries
of Financial Folly, Princeton University Press,
2009, or Carmen Reinhart and Vincent Reinhart,
Beware Those Who Think the Worst Is Past,
Financial Times, August 30, 2010.
8. Investment Strategy Group, Questioning the
Role of US Assets in a Portfolio, July 6, 2009.
9. International Energy Agency, World Energy
Outlook 2012, OECD/IEA, 2012.
10. Ernest Miguelez and Carsten Fink, Measuring
the International Mobility of Inventors: A
New Database, World Intellectual Property
Organization, May 2013.
11. OECD, OECD Science, Technology and Industry
Outlook 2014, June 2014.
12. Ernst & Young, Adapting and Evolving: Global
Venture Capital Insights and Trends 2014,
January 2014.
13. For companies with a market capitalization above
$100 million in the Bloomberg World Index.
14. Dale W. Jorgenson, Mun Ho and Jon Samuels,
Information Technology and US Productivity
Growth: Evidence from a Prototype Industry
Production Account, Journal of Productivity
Analysis, October 2011.
15. The Heritage Foundation, 2014 Index of
Economic Freedom, November 2013.
16. World Bank, Doing Business 2015: Going
Beyond Efficiency, October 29, 2014.
17. McKinsey & Company, Prospects for Growth:
An Interview with Robert Solow, McKinsey
Quarterly, September 2014.
18. Henri Poincar, Science and Hypothesis, 1905.
19. These forecasts have been generated by ISG
for informational purposes as of the date of
this publication. Return targets are based on
ISGs framework, which incorporates historical
valuation, fundamental and technical analysis.
Dividend yield assumptions are based on each
indexes trailing 12-month dividend yield. They
are based on proprietary models and there
can be no assurance that the forecasts will be
achieved. Please see additional disclosures

at the end of this publication. The following


indexes were used for each asset class: Barclays
Municipal 1-10Y Blend (Muni 1-10); BAML US
T-Bills 0-3M Index (Cash); JPM Government
Bond Index Emerging Markets Global Diversified
(Emerging Market Local Debt); HFRI Fund of
Funds Composite (Hedge Funds); MSCI EM US$
Index (Emerging Market Equity); Barclays US
Corporate High Yield (US High Yield); Barclays
US High Yield Loans (Bank Loans); MSCI UK
Local Index (UK Equities); MSCI EAFE Local Index
(EAFE Equity); S&P Banks Select Industry Index
(US Banks); MSCI Japan Local Index (Japanese
Equity).
20. Chair Janet L. Yellen, Labor Market Dynamics
and Monetary Policy, speech delivered at the
Federal Reserve Bank of Kansas City Economic
Symposium in Jackson Hole, Wyo., August 22,
2014.
21. Investment Strategy Group, European Sovereign
Debt Crisis: Uncertain, Uncharted, and Certainly
Unsettling, August 21, 2011.
22. Harold Sirkin, Michael Zinser and Justin
Rose, The Shifting Economics of Global
Manufacturing: How Cost Competitiveness Is
Changing Worldwide, The Boston Consulting
Group, August 19, 2014.
23. The Editorial Board, A Cease-Fire in Ukraine,
The New York Times, September 5, 2014.
24. Gregory L. White and Anton Troianovski, Putins
Year of Defiance and Miscalculation, The Wall
Street Journal, December 17, 2014.
25. Anders Aslund, 12 Ways in Which Putins
Rhetoric Resembles Germany in the 1930s,
KyivPost, March 21, 2014.
26. Goldman Sachs, Investing Insights: Geopolitical
Hot Spots and Their Investment Implications,
Forum, Volume 7, Issue 1, September 2014.
27. Investment Strategy Group, Have Geopolitical
Risks Reached a Tipping Point? September 11,
2014.
28. The White House, Statement by the President
on ISIL, September 10, 2014.
29. Richard Haass, Time to End the North Korean
Threat, The Wall Street Journal, December 23,
2014.
30. Jane Perlez, Chinese Annoyance with North
Korea Bubbles to the Surface, The New York
Times, December 20, 2014.
31. Connie Robertson, The Wordsworth Dictionary of
Quotations, Wordsworth Editions, 1998.
32. Bank of America Merrill Lynch, Im a
CommodityGet me Out of Here, December
4, 2014.
33. The CAI uses a broad collection of economic
variables, both hard spending data and survey
data, which seek to provide a more timely read
on underlying economic trends.
34. Cornerstone Macro, U.S. Business Confidence
Rose to the Highest Since 2006, December 4,
2014.

35. Goldman Sachs Global Investment Research,


Lower Oil Prices: More Sugarplums than Lumps
of Coal, December 19, 2014.
36. Ibid.
37. Goldman Sachs Global Investment Research,
Cheaper Crude with a Weaker EuroA Boost to
Growth and a Small Drag on Inflation, October
15, 2014.
38. Bank of America Merrill Lynch, 2015: Pax
Americana, iBubble & FX Wars, November 23,
2014.
39. JP Morgan, What Have We Learned this Year?
December 12, 2014.
40. Bank of America Merrill Lynch, Im a
CommodityGet Me Out of Here, December
4, 2014.
41. Goldman Sachs Global Investment Research, Let
it Grow: Markets Take Policy-Rate-Hike Cycles in
Stride, September 10, 2014.
42. Note: Forecasts have been generated by ISG
for informational purposes as of the date of
this presentation. Return targets are based on
a combination of trend and forward earnings
estimates.
43. Goldman Sachs Global Investment Research,
US Daily: Revisiting the Risk of Another Bust,
November 3, 2014.
44. Empirical Research Partners, Portfolio Strategy,
November 7, 2014.
45. Alister Bull, Fischer: Recent Japanese Policy
Actions Have Been Appropriate, Bloomberg
News, December 2, 2014.
46. Based on the JPM GBI-EM Global Diversified
Index.
47. The following indexes were used for each asset
class: Barclays United States Treasury Bellwether
10 Years (10-Year US Treasury); Barclays United
States Treasury TIPS(US Treasury TIPS); Barclays
Municipal Bond : High Yield (Muni High Yield);
Barclays United States Corporate High Yield (US
Corporate High Yield); Barclays Municipal 1 - 10
Years Blend (US Muni 1-10 Year); Barclays United
States High Yield Loans (Bank Loans); JPM GBIEmerging Markets Global Diversified Composite
(USD) (EM Local Debt); JPM EMBI Global
Diversified Composite(EM US Dollar Debt); JPM
GBI Germany 7 - 10 Years (Euro)(Germany 7-10
Year (Local)); JPM European Monetary Union
Government 7 - 10 Years (Euro)( EMU 7-10 Year
(Local)); United States, All Urban Consumers, U
S City Average, Consumer Prices, All Items, SA,
Index, 1982-1984 = 100 (US Inflation (%YoY)).
48. JP Morgan, 2014 High-Yield Annual Review,
December 4, 2014.
49. Anjli Raval, Opec Leader Vows Not to Cut Oil
Output Even If Price Hits $20, Financial Times,
December 22, 2014.
50. Based on data through Q3 2014.

The co-authors give special thanks to:


Matheus Dibo
Associate
Travis Pfander
Associate
Mary Craig
Associate
Paul Swartz
Vice President
Additional contributors from the Investment
Strategy Group include:
Venkatesh Balasubramanian
Vice President
Thomas Devos
Vice President
Andrew Dubinsky
Vice President
Oussama Fatri
Vice President
Gregory Mariasch
Vice President
Howard Spector
Vice President
Giuseppe Vera
Vice President
Harm Zebregs
Vice President
Lili Zhu
Associate

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